Willingness to make house calls or conform to unconventional hours; or

Transcription

1 P R I C E T A K E R S A N D T H E C O M P E T I T I V E P R O C E S S Characteristics of Competition Competition as a dynamic process denotes rivalry between independent producers. Competition directs self-interest toward mutual cooperation and, thus, the social good. As Adam Smith noted in The Wealth of Nations, persons are usually motivated by a desire to better their own position, rather than by benevolence: As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. Competition involves virtually unconstrained rivalry rivalry to independently outperform the competition in the free marketplace. Competition can take many forms: Quality of the product or service; Convenience of location; Advertising; Optional features; Colors; Variety of products; Availability of a product or service; Willingness to make house calls or conform to unconventional hours; or Price. Benefits of Competition Competition is generally considered a good thing in economics for several reasons: 1. Producers tend to cater to consumer s stated preferences. If one producer doesn t have what you want, another probably will; Price Takers and the Competitive Process Page 1 2/24/10

2 2. Pressure is placed upon producers to make quality products. Producers who make poor quality products or who provide poor service tend to have difficulty hanging on to customers and are likely to go out of business; 3. Pressure is placed on producers to operate efficiently and to reduce waste in the production process. Profits (and losses) are signals sent out by consumers as to the relative value of a firm s output. Competition tends to weed out inefficient firms. Bankruptcies and other business failures may not be such a bad thing if they serve to allocate resources to more productive endeavors; 4. Competition promotes innovation. Today s goods may not be desired tomorrow. The firm that invents the better mousetrap gets the customers and makes the profits. (Sometimes, we don t seem to appreciate this benefit of competition. Currently, Microsoft Corporation is being assaulted by the Department of Justice for being too competitive.); and 5. Competition results in lower prices to consumers. All of these benefits are only truly realized in a hypothetical model of industrial structure called perfect (or pure) competition. Price Takers Price takers produce identical products and each seller is small relative to the market. Each seller has little or no effect on the market price. Each firm can sell as much as it wants at the market price It is unable to sell any output at a price greater than the market price. Example: agriculture (wheat, corn, soybeans) It is also called a purely competitive market. Price Searchers Price Searchers face a downward sloping demand curve for their product. The amount that the firm is able to sell is inversely related to the price it charges. Examples: Nike General Motors Exxon most retail stores Price Takers and the Competitive Process Page 2 2/24/10

3 Assumptions of the Model of Perfect Competition The model of perfect competition begins with certain simplifying assumptions. Some of these assumptions will be removed or changed as we consider models of other industrial structures. 1. Homogeneous product All products in a competitive market are identical. This rules out advertising advantage, locational preferences, quality differences, and all other forms of nonprice competition; 2. The market is characterized by a large number of independent firms. There is no collusion among sellers. In fact the large number of sellers guarantees that collusion cannot be successful; 3. Each buyer and seller is small relative to the total market. No single buyer or seller can influence the market price; Market forces (supply & demand) determine price. Price takers have no control over the price that they may charge in the market. If such a firm was to charge a price above that established by the market, consumers would simply buy elsewhere. Thus, the firm s demand curve is perfectly elastic it is horizontal at the price determined in the market; and 4. It is assumed that there is free entry into and exit from the market. No barriers to entry or exit exist. For example, there are no licensing requirements, no financial barriers, no legal or regulatory restrictions that would prevent anyone from establishing a business in this market at any time they choose. Likewise, no firm is obligated to provide goods or services to the market if it chooses to leave the market. Being a small part of the market and unable to noticeably affect the market price, each seller in the market must accept whatever price is established by the market. Price Takers and the Competitive Process Page 3 2/24/10

4 Again, firms in this type of market are called price takers. The seller cannot sell any products above that price because consumers can find another seller who is willing to provide the product at the market price. And there is no cost to the consumer for taking his business elsewhere. Recall that there are no locational preferences. However, the seller can sell all he wants at the market price. These assumptions lead us to conclude that a firm in a perfectly competitive market will face a perfectly elastic demand curve: Short Run Production If we place the demand curve facing a perfectly competitive firm on the same graph as the cost structure facing a typical firm, we can determine at what output level a profit-maximizing firm will operate. It is at the output level where the production of one more unit of the product adds just as much to total costs as the sale of that unit adds to total revenue. This occurs where marginal cost (MC) equals marginal revenue (MR). You may have noticed that the graph showing the perfectly elastic demand curve does not show a label for marginal revenue. But consider what marginal revenue is: the addition to total revenue that results from the sale of one more unit of a product. The additional revenue that results from the sale of an item is the price for which it sells. That is, marginal revenue is equal to price in a perfectly competitive market. Price Takers and the Competitive Process Page 4 2/24/10

5 In a price taker market, marginal revenue (MR) = market price, because all units are sold at the same price (market price). What happens if the firm operates at an output level less than where MC=MR? The production and sale of additional units would add more to total revenue than they would add to total costs. Why not produce and sell those additional units? What happens if the firm operates at an output level greater than where MC=MR? The production and sale of additional units would add more to total costs than they would add to total revenue. Why produce and sell those additional units? If demand is strong (a high demand curve), we would expect the firm to make a profit. The graph above shows that this is in fact the case. What happens if demand is weak (a low demand curve)? We might expect the firm to suffer losses. This situation is shown in the following graph: Price Takers and the Competitive Process Page 5 2/24/10

6 When this situation occurs, a firm has three options: 1. Continue operating at an output level where MC=MR, thereby minimizing losses while still producing its product; 2. Temporarily shut down, thereby eliminating variable costs of production, and wait for demand to rise again; or 3. Go out of business, thereby eliminating both variable and fixed costs of production, if it is expected that demand will not rise again in the near future. As drawn, this graph would suggest that the firm should only continue to operate at the output level where MC=MR if the market price is expected to rise in the near future. If, however, the demand curve fell as indicated in the following graph, the firm would be best advised to shut down temporarily since variable costs would be eliminated and only fixed costs would be incurred: Price Takers and the Competitive Process Page 6 2/24/10

7 If, however, it were expected that the market price would not go up in the near future, going out of business would be the preferred alternative. The producer makes such a decision subjectively. If the expected value of future revenue is less that the expected value of future costs, the firm would permanently shut down and go out of business. Short Run Market Supply The firm s short-run supply curve: A firm maximizes profits when it produces at P = MC and variable costs are covered. A firm s short-run supply curve is the segment of its marginal cost curve above average variable cost. The market s short-run supply curve: The short-run market supply curve is the horizontal summation of the all the firms short-run supply curves (segment of firms MC curves above AVC). Supply Curve for the Firm & Market Given resource prices, the firm s marginal cost curve (above AVC) is the firm s supply curve. As price rises above the short-run shutdown price of P 1, the firm will supply additional units of the good. The short-run market supply curve (S sr ) is merely the sum of the firms supply (MC) curves. Note that below P 1 no quantity is supplied as P < AVC. Price Takers and the Competitive Process Page 7 2/24/10

8 Economic Profits and Entry If price exceeds average total cost, firms will earn an economic profit. Economic profit induces both: 1. the entry of new firms, and 2. expansion in the scale of operation of existing firms. Capital moves into the industry, shifting the market supply to the right. This will continue until price falls to ATC. In the long-run, competition drives economic profit to zero. Economic Losses and Exit If average total cost exceeds price, firms will suffer an economic loss. Economic losses induce: 1. the exit of firms from the market, and 2. a reduction in the scale of operation of the remaining firms. As market supply decreases, price will rise to average total cost. Thus, profits and losses move price toward the zero-profit long-run equilibrium. Long Run Equilibrium The two conditions are necessary for long-run equilibrium in a price-taker market. The quantity supplied and the quantity demanded must be equal in the market, as shown below at P 1 with output Q 1. Given the price established in the market, firms in the industry must earn zero economic profit (P = ATC). Price Takers and the Competitive Process Page 8 2/24/10

9 Adjusting to Expansion in Demand Consider the market for toothpicks. A new candy that sticks to teeth causes the market demand for toothpicks to increase from D 1 to D 2 shifting the firm s demand curve upward. At the higher price, firms expand output to q 2 and earn short-run profits. Economic profits will draw competitors into the industry, shifting the market supply curve from S 1 to S 2. After the increase in market supply, a new equilibrium is established at the original market price P 1 and a larger rate of output (Q 3 ). As the market price returns to P 1, the demand curve facing the firm returns to its original level. In the long-run, economic profits are driven down to zero. Note that here the long-run market supply curve is flat (S lr ). Price Takers and the Competitive Process Page 9 2/24/10

10 Similar adjustments take place in response to a reduction in demand. Long Run Supply As adjustments take place in a perfectly competitive market, the market price may gradually creep up or down, or it may stay approximately level. Plotting these changes gives us a long run average total cost curve (LRATC). The actual shape of the LRATC curve depends on what happens to the costs of production as the total output of the industry is altered. 1. Decreasing cost industries are characterized by falling costs as output increases over time. Examples include the computer industry, handheld calculators, televisions, and other hightech industries. In these cases, the LRATC curve is downward sloping; 2. Constant cost industries are characterized by costs that remain relatively constant over time. This situation suggests that factor prices and production costs remain constant as industry output rises. In these cases, the LRATC curve is horizontal; Price Takers and the Competitive Process Page 10 2/24/10

11 3. Increasing cost industries are characterized by costs that increase over time. This situation suggests that factor prices and production costs increase as industry output rises. In these cases, the LRATC curve is upward sloping. An example of this kind of an industry might include a mining or timber industry where depletion of natural resources reduces the market supply relative to demand. Of course, these examples also assume that the level of technology does not change and that efforts are not made to replenish renewable natural resources such as trees. Consider an increase in the market demand that leads to a higher market price, leading to shortrun profits for firms. Economic profit entices some new firms to enter the market and others to increase the scale of their operation the market supply curve out. The stronger demand for resources (inputs) pushes their price up. Consequently, the firm s costs are now higher (ATC 2 & MC 2 ). Price Takers and the Competitive Process Page 11 2/24/10

12 The competitive process continues until economic profits are eliminated. This occurs at equilibrium price P 3 < P 2 and output level Q 3 > Q 2. Because this is an increasing-cost industry, expansion in market output leads to a higher equilibrium price. Thus, the long-run supply curve S lr is upward sloping. Supply Elasticity and the Role of Time In the short run, fixed factors of production such as plant size limit the ability of firms to expand output quickly. In the long run, firms can alter plant size and other fixed factors of production. Therefore, the market supply curve will be more elastic in the long run than in the short run. Price Takers and the Competitive Process Page 12 2/24/10

13 The slope of the market supply curve becomes flatter and flatter (more and more elastic) as the time horizon expands. Summarizing Perfect Competition In summary, perfect competition leads to lower consumer prices, only short run profits for producers, and no long run profits. A producer in a perfectly competitive market only earns normal profits unless he is able to figure out a way to reduce costs. Any economic profits earned in the short run will prompt other firms to employ similar cost-cutting measures so that they too can enjoy short run economic profits. However, in the long run, the lack of barriers to entry allows other firms into the market which forces the market price down until short run economic profits are eliminated. There may be no real-world example of a perfectly competitive industry. Perhaps the closest example would be the agricultural industry if all government intervention were removed. A Diversion to Consider Profits Firms earn an economic profit by producing goods that can be sold for more than the cost of the resources required for their production. Profit is a reward for production of a product that has greater value than the value of the resources required for its production. Losses are a penalty for the production of a good that consumers value less highly than the value of the resources required for its production. The competitive process provides a strong incentive for producers to operate efficiently and heed the views of consumers. Competition and the market process harness self-interest and use it to direct producers into wealth-creating activities. Price Takers and the Competitive Process Page 13 2/24/10