Lecture 12: Competitive Markets

Outline:

1. Distinguishing between market structure and market behavior

2. Four market structures

3. Assumptions of Perfect Competition (PC)

4. Demand and Revenue for a PC firm

i. Demand curve of the Industry

ii. Demand curve facing the firm

iii. Total Revenue (TR), Average Revenue (AR), Marginal Revenue (MR)

iv. P=MR for the PC firm

5. Short Run Rules for all profit maximizing firms

i. Profit maximizing level of output (MR=MC)

ii. Should the firm produce that level of output (P>AVC)

6. Applying the rules of profit maximization to the PC firm

1. Market Structure and Market Behavior:

Market structure:

refers to all of the features of a market that may affect the behavior and performance of firms (eg. Number of firms, type of product, ease of entry into the market, control over price)

Market behavior:

refers to the extent to which firms actively compete with one another.

The seeming paradox in the relationship between market structure and market behavior:

The less power an individual firm has to influence the market in which it operates - the more competitive the market is said to be - but the less actively firms compete with one another in the market.

For example:

Competitive market structure:

The competitiveness of the market is the extent to which firms have power to influence market prices or any other terms on which their product is sold.

In a perfectly competitive market - firms have zero market power.

Example: A corn farmer in the Midwest. One farmer has no power over the price of corn because s/he is such a small producer in relation to the whole market, and her/his corn is not distinguishable from that of any other farmer.

Question: If an individual farmer tried to raise the price of corn what would happen?

Competitive behavior:

Refers to the degree that firms actively compete with one another.

Firms exhibit competitive behavior when they have significant power to influence the price of the good they produce or the terms at which the good is sold.

In a perfectly competitive market - firms have no incentive to actively compete with one another because none of them has any power.

Firms compete actively with one another in markets that are not perfectly competitive.

Example: Airline companies compete with one another because they have some real power in the market. They can charge lower prices and attract customers from other companies, and they can often charge higher prices and keep their customers because of scheduling, routes, convenience, quality, etc.

In an imperfectly competitive market - firms have an incentive to compete with one another because their actions can affect what happens in the market.

2. Market structures:

A Spectrum exists from most competitive market structure to least competitive market structure

Perfect competition

(MOST)

Monopolistic competition

Oligopoly

Monopoly

(LEAST)

3. Assumptions of Perfect Competition:

1. Firms produce a homogeneous product

2. Customers have perfect information about the product

3. Firms are small in relation to the market as a whole

4. Each firm is a price taker

5. The industry is characterized by ease of entry and exit

4. Demand and Revenue for a PC firm:

GRAPHS:

side-by-side graphs of the industry and the firm

* Demand curve of the PC industry - the market demand curve.

* Demand curve of the PC firm - a horizontal demand curve.

(Firm is a price-taker)

Note: The firm's demand curve determines what revenues it will earn.

Perfectly elastic demand curve and the firm's revenue:

Total revenue: the total amount the firm earns from sales

TR = P * Q

When P is constant the TR curve is a straight line.

Graph

Average revenue: the revenue the firm earns from sales per unit of output

AR = TR/ Q

When P is constant AR = P

Marginal revenue: the extra revenue the firm earns from selling an extra unit of output

MR = change in TR / change in Q

(MR is the slope of the TR curve)

When P is constant the slope of the TR curve is constant and equal to P so MR =P

Graphs

Note: For a PC firm, P=MR=AR

5. Short Run Rules for all profit maximizing firms:

Rule 1:

The profit maximizing level of output (q*) for the firm is determined by MR=MC.

Note:

q* is found by reading down from the point where MR =MC

Example to illustrate this rule.

Rule 2:

The firm should produce the profit maximizing level of output (q*) if it is making more profit than if it shut down.

In the SR: Keep producing q* as long as P AVC

Example to illustrate this rule.

In the LR: Keep producing q* as long as P AC

Example to illustrate this rule.

6. Applying the short run rules of profit maximization to the PC firm:

Using a graph of the costs and revenues of the firm:

Rule 1: Find q* where MR = MC

Rule 2: Is P AVC at q*?

* Note: For the PC firm since P=MR, when the firm is profit maximizing at MR = MC, it is also true that P=MC