Lecture 12: Competitive Markets

1. Market Structure and Firm Behavior

The following diagram summarizes the relationship between market structure and firm behavior:

Market Structure:      PERFECTLY COMPETITIVE                                                  IMPERFECTLY COMPETITIVE
                                                     |                                                                                                         |
Firmsí market
Power:                       Firms cannot influence market price                                             Firms can influence market price
                                                     |                                                                                                         |

Firm Behavior:              FIRMS DONíT ACTIVELY                                                           FIRMS DO ACTIVELY
                                   COMPETE WITH ONE                                                                   COMPETE WITH ONE
                                       ANOTHER                                                                                        ANOTHER

The link between structure and behavior is the extent to which firms have power to affect market price.  The less power an individual firm has over the market price of the good it sells, the more competitive the market is said to be, but firms will not compete actively with one another.

Competitive market structure: Firms donít have power to influence market price.

Competitive behavior: Firms actively vie with one another for business.

Economists model the behavior of firms in four theoretical market structures that fall along a spectrum:

Perfect Competition                 Monopolistic Competition                          Oligopoly                                               Monopoly
Most competitive                                                                                                                                                 Least competitive
Market structure                                                                                                                                                     market structure
                                                                                    Imperfect Competition

2. The theory of Perfect Competition

a. Characteristics of a perfectly competitive (PC) market:

1. All firms sell an identical (homogeneous) product.
2. Consumers have perfect information about the product and its price.
3. There are many small firms in the market (each firmís min LRAC is small compared with the market output.
4. There is freedom of entry and exit in the market.

Characteristics (1)-(3): Establish that individual firms are price takers Ė they take the market price as given and changes in their output do not affect the market price.

Characteristic (4): Is important for the long run profits firms in this market can earn.

b. The demand curve the PC firm faces

Note: this is the main factor distinguishing the PC firm from firms operating in other types of markets.

The demand curve that each firm faces is horizontal (perfectly elastic) since the firm cannot influence the price of the good with changes in its output.

Graph (insert here):

c. Total, Average, and Marginal Revenue

A firmís revenue will depend on the nature of the demand curve that it faces.

Total Revenue (TR) is the total amount received by the firm from the sale of its product.  If q units are sold at price p, then TR = p*q

Average Revenue (AR) is the revenue the firm earns per unit of output sold (AR=P)

AR = TR/q = p*q/q = p

Marginal Revenue (MR) is the change in the firmís TR resulting from a change in its sales by 1 unit of output.

MR = change in TR/ change in q

If the firm faces a horizontal demand curve, then the demand curve is also the AR and MR curve.

Q. Why is that?

If the firm can sell an extra unit of output at price, P, and it sells all its output at that price, then its revenue per unit of output is equal to P, and the extra revenue it earns from selling that extra unit of output is also equal to P.

Graph (insert here):

Example: Table 10-1 in the textbook.

d. Rules for ALL profit maximizing firms:

All firms that maximize profits have to decide whether to produce at all, and if so, how much to produce.  The following rules apply to all profit maximizing firms.

Should the firm produce at all?

The firm has the option of producing various quantities of output, including zero (not producing at all).

If the firm stops producing in the SR, it will incur a loss equal to its TFC.

If the firm produces in the SR, it will incur TVC as well as TFC.

Since the firm has to pay its fixed costs in either case, it will continue to produce in the SR as long as it can find an output where TR>TVC.

RULE 1: A firm should not produce at all if for all levels of output TVC > TR or alternatively if AVC > P.
This is often called the Shut-down Rule.

How much should the firm produce?

If the firm decides to produce according to Rule 1, how much output should it produce?

Thinking about this incrementally:
- if an given unit of output adds more to revenue than to cost Ė the firmís profits will be increased by producing and selling it.
- If any given unit of output adds more to cost than to revenue Ė the firmís profits will be decreased by producing and selling it.

A unit of output will increase the firmís profits if MR > MC
A unit of output will decrease the firmís profits if MR < MC

Therefore, the firm will have no incentive to change its output (profits will be maximized) if MR =MC.

Rule 2: If a firm finds it worthwhile to produce at all, the firm should produce the output at which MR=MC in order to maximize profits.
This is often called the profit maximization rule.

Graphs illustrating the application of Rule 2 to a price taking firm (a firm facing a horizontal demand curve):

Notice:  For a price-taking firm: MR = P.

e. Short run supply curves

How much will a competitive firm supply at every price?

The profit maximizing firm will produce where P=MC (As long as P > AVC).  For every possible price, the MC curve (above AVC) gives the firmís profit maximizing output.

Graphs (insert here):

Individual firmís supply curve:            Is MC curve above AVC.
Market supply curve:                         Is the horizontal sum of all individual firmsí supply curves.

f. SR equilibrium in a competitive market

The equilibrium price and quantity in a competitive market are determined by the forces of supply and demand and although no individual firm can affect that, the collective behavior of firms is important in determining equilibrium price and quantity.

When a market is in SR equilibrium, each firm is maximizing profits (producing where MR=MC).

If a market is in SR equilibrium, firms are doing as well as they can given their circumstances.

To say that a firm is maximizing profits though, doesnít tell us how large those profits are Ė or even if it is making profits rather than losses.

There are three possible situations that a firm can be in, in SR equilibrium:
1. The firm is making economic profits: revenue per unit of output (P) is greater than cost per unit of output (ATC).
Graph of economic profits.

2. The firm is making normal profits:
Graph of normal profits

3. The firm is making losses but will continue to produce
Graph of losses in SR

Q. What would the graph of a competitive firm that decides not produce at all in the SR, look like?