Chapter 1. The Economic Way of Thinking 40 Leave Men Free The lesson I have to teach is this: Leave all creative energies uninhibited. Merely organize society to act in harmony with this lesson. Let society’s legal apparatus remove all obstacles the best it can. Permit creative know-how to freely flow. Have faith that free men will respond to the “Invisible Hand.” This faith will be confirmed. I, Pencil, seemingly simple though I am, offer the miracle of my creation as testimony that this is a practical faith, as practical as the sun, the rain, a cedar tree, and the good earth. CHAPTER 2 Competitive Product Markets And Firm Decisions Competition, if not prevented, tends to bring about a state of affairs in which: first, everything will be produced which somebody knows how to produce and which he can sell profitably at a price at which buyers will prefer it to the available alternatives: second, everything that is produced is produced by persons who can do so at least as cheaply as anybody else who in fact is not producing it: and third, that everything will be sold at prices lower than, or at least as low as, those at which it could be sold by anybody who in fact does not do so. Friedrich Hayek n the heart of New York City, Fred Lieberman’s small grocery is dwarfed by the tall buildings that surround it. Yet it is remarkable for what it accomplishes. Lieberman’s carries thousands of items, most of which are not produced locally, and some of which come thousands of miles from other parts of this country or abroad. A man of modest means, with little knowledge of production processes, Fred Lieberman has nevertheless been able to stock his store with many if not most of the foods and toiletries his customers need and want. Occasionally Lieberman’s runs out of certain items, but most of the time the stock is ample. Its supply is so dependable that customers tend to take it for granted, forgetting that Lieberman’s is one small strand in an extremely complex economic network. How does Fred Lieberman get the goods he sells, and how does he know which ones to sell and at what price? The simplest answer is that the goods he offers and the prices at which they sell are determined through the market process- the interaction of many buyers and sellers trading what they have (their labor or other resources) for what they want. Lieberman stocks his store by appealing to the private interests of suppliers -- by paying them competitive prices. His customers pay him extra for the convenience of purchasing goods in their neighborhood grocery -- in the process appealing to his private interests. To determine what he should buy, Fred Lieberman considers his suppliers prices. To determine what and how much they should buy, his customers consider the prices he charges. The Nobel Prize-winning economist Friedrich Hayek has suggested that the market process is manageable for people like Fred Lieberman precisely because prices condense into usable form a great deal of information, signaling quickly what people want, what goods cost, and what resources are readily available. Prices guide and coordinate the sellers’ production decisions and consumers’ purchases. How are prices determined? That is an important question for people in business simply because an understanding of how prices are determined can help business people understand I Chapter 2 Competitive Product Markets 2 the forces that will cause prices to change in the future and, therefore, the forces that affect their businesses’ bottom lines. There’s money to be made in being able to understand the dynamics of prices. Our most general answer in this chapter to the question is deceptively simple: In competitive markets, the forces of supply and demand establish prices. However, there is much to be learned through the concepts of supply and demand. Indeed, we suspect that most MBA students will find supply and demand the most useful concepts developed in this book. However, to understand supply and demand, you must first understand the market process that is inherently competitive. The Competitive Market Process So far, our discussion of markets and their consequences has been rather casual. In this section we will define precisely such terms as market and competition. In later sections we will examine the way markets work and learn why, in a limited sense, markets can be considered efficient systems for determining what and how much to produce. The Market Setting Most people tend to think of a market as a geographical location -- a shopping center, an auction bar, a business district. From an economic perspective, however, it is more useful to think of a market as a process. You may recall from Chapter 1 that a market is defined as the process by which buyers and sellers determine what they are willing to buy and sell and on what terms. That is, it is the process by which buyers and sellers decide the prices and quantities of goods to be bought and sold. In this process, individual market participants search for information relevant to their own interests. Buyers ask about the models, sizes, colors, and quantities available and the prices they must pay for them. Sellers inquire about the types of goods and services buyers want and the prices they are willing to pay. This market process is self-correcting. Buyers and sellers routinely revise their plans on the basis of experience. As Israel Kirzner has written, The overly ambitious plans of one period will be replaced by more realistic ones; market opportunities overlooked in one period will be exploited in the next. In other words, even without changes in the basic data of the market, the decision made in one period onetime generates systematic alterations in corresponding decisions for the succeeding period. 1 The market is made up of people, consumers and entrepreneurs, attempting to buy and sell on the best terms possible. Through the groping process of give and take, they move from relative ignorance about others’ wants and needs to a reasonably accurate understanding of 1 Israel Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973), p. 10. Chapter 2 Competitive Product Markets 3 how much can be bought and sold and at what price. The market functions as an ongoing information and exchange system. Competition Among Buyers and Among Sellers Part and parcel of the market process is the concept of competition. Competition is the process by which market participants, in pursuing their own interests, attempt to outdo, outprice, outproduce, and outmaneuver each other. By extension, competition is also the process by which market participants attempt to avoid being outdone, outpriced, outproduced, or outmaneuvered by others. Competition does not occur between buyer and seller, but among buyers or among sellers. Buyers compete with other buyers for the limited number of goods on the market. To compete, they must discover what other buyers are bidding and offer the seller better terms -- a higher price or the same price for a lower-quality product. Sellers compete with other sellers for the consumer’s dollar. They must learn what their rivals are doing and attempt to do it better or differently -- to lower the price or enhance the product’s appeal. This kind of competition stimulates the exchange of information, forcing competitors to reveal their plans to prospective buyers or sellers. The exchange of information can be seen clearly at auctions. Before the bidding begins, buyer look over the merchandise and the other buyers, attempting to determine how high others might be willing to bid for a particular piece. During the auction, this specific information is revealed as buyers call out their bids and others try to top them. Information exchange is less apparent in department stores, where competition is often restricted. Even there, however, comparison-shopping will often reveal some sellers who are offering lower prices in an attempt to attract consumers. In competing with each other, sellers reveal information that is ultimately of use to buyers. Buyers likewise inform sellers. From the consumer’s point of view, The function of competition is here precisely to teach us who will serve us well: which grocer or travel agent, which department store or hotel, which doctor or solicitor, we can expect to provide the most satisfactory solution for whatever particular personal problem we may have to face. 2 From the seller’s point of view -- say, the auctioneer’s -- competition among buyers brings the highest prices possible. Competition among sellers takes many forms, including the price, quality, weight, volume, color, texture, poor durability, and smell of products, as well as the credit terms offered to buyers. Sellers also compete for consumers’ attention by appealing to their hunger and sex drives or their fear of death, pain, and loud noises. All these forms of competition can be divided into two basic categories -- price and nonprice competition. Price competition is of particular interest to economists, who see it as an important source of information for market 2 Friedrich H. Hayek, “The Meaning of Competition,” Individualism and Economic Order (Chicago: University of Chicago Press, 1948), p. 97. Chapter 2 Competitive Product Markets 4 participants and a coordinating force that brings the quantity produced into line with the quantity consumers are willing and able to buy. In the following sections, we will construct a model of the competitive market and use it to explore the process of price competition. Nonprice competition will be covered in a later section. Supply and Demand: A Market Model A fully competitive market is made up of many buyers and sellers searching for opportunities or ready to enter the market when opportunities arise. To be described as competitive, therefore, a market must include a significant number of actual or potential competitors. A fully competitive market offers freedom of entry: there are no legal or economic barriers to producing and selling goods in the market. Our market model assumes perfect competition-an ideal situation that is seldom, if ever, achieved in real life but that will simplify our calculations. Perfect competition is a market composed of numerous independent sellers and buyers of an identical product, such that no one individual seller or buyer has the ability to affect the market price by changing the production level. Entry into and exit from a perfectly competitive market is unrestricted. Producers can start up or shut down production at will. Anyone can enter the market, duplicate the good, and compete for consumers’ dollars. Since each competitor produces only a small share of the total output, the individual competitor cannot significantly influence the degree of competition or the market price by entering or leaving the market. This kind of market is well suited to graphic analysis. Our discussion will concentrate on how buyers and sellers interact to determine the price of tomatoes, a product Mr. Lieberman almost always carries. It will employ two curves. The first represents buyers’ behavior, which is called their demand for the product. The Elements of Demand To the general public, demand is simply what people want, but to economists, demand has much more technical meaning. Demand is the assumed inverse relationship between the price of a good or service and the quantity consumers are willing and able to buy during a given period, all other things held constant. Demand as a Relationship The relationship between price and quantity is normally assumed to be inverse. That is, when the price of a good rises, the quantity sold, ceteris paribus (Latin for “everything else held constant”), will go down. Conversely, when the price of a good falls, the quantity sold goes up. Demand is not a quantity but a relationship. A given quantity sold at a particular price is properly called quantity demanded. Chapter 2 Competitive Product Markets 5 Both tables and graphs can be used to describe the assumed inverse relationship between price and quantity. Demand as a Table or a Graph Demand may be thought of as a schedule of the various quantities of a particular good consumers will buy at various prices. As the price goes down, the quantity purchased goes up and vice versa. Table 2.1 contains a hypothetical schedule of the demand for tomatoes in the New York area during a typical week. The middle column shows prices that might be charged. The column on the right shows the number of bushels consumers will buy at those prices. Note that as the price rises from zero to $11 a bushel, the number of bushels purchased drops from 110,000 to zero. Demand may also be thought of as a curve. If price is scaled on a graph’s vertical axis and quantity on the horizontal axis, the demand curve has a negative slope (downward and to the right), reflecting the assumed inverse relationship between price and quantity. The shape of the market demand curve is shown in Figure 2.1, which is based on the data from Table 2.1. Points a through l on the graph correspond to the price-quantity combinations A through L in the table. Note that as the price falls from P 2 ($8) to P 1 ($5), consumers move down their demand curve from a quantity of Q 1 (30) to the larger quantity Q 2 (60). 3 The Slope and Determinants of Demand Price and quantity are assumed to be inversely related for two reasons. First, as the price of a good decreases (and the prices of all other goods stay the same -- remember ceteris paribus), the purchasing power of consumer incomes rises. More consumers are able to buy the good, and many will buy more of most goods. (This response is called the income effect.) In addition, as the price of a good decreases (and the prices of all other goods remain the same), the good becomes relatively cheaper, and consumers will substitute that good for others. (This response is called the substitution effect.) 3 Mathematically, the demand relationship may be stated as Q d = a – bP, where Q d is the quantity demanded at every price; a is the quantity consumers will buy when the price is zero; b is the slope of the demand curve; and P is the price of the good. Thus the demand function for tomatoes described in Table 2.1 and Figure 2.1 may be written as Q d = 110,000 – 10,000 P. Chapter 2 Competitive Product Markets 6 TABLE 2.1 Market Demand for Tomatoes Price-Quantity Combinations Price per Bushel Number of Bushels A $0 110,000 B 1 100,000 C 2 90,000 D 3 80,000 E 4 70,000 F 5 60,000 G 6 50,000 H 7 40,000 I 8 30,000 J 9 20,000 K 10 10,000 L 11 0 FIGURE 2.1 Market Demand for Tomatoes Demand, the assumed inverse relationship between price and quantity purchased, can be represented by a curve that slopes down toward the right. Here, as the price falls from $11 to zero, the number of bushels of tomatoes purchased per week rises from zero to 110,000. In sum, when the price of tomatoes (or razorblades or any other good) falls, more tomatoes will be purchased because more people will be buying them for more purposes. Although price is an important part of the definition of demand, it is not the only determinant of how much of a good people will want. It may not even be the most important. The major factors that affect market demand are called determinants of demand. They are: • Consumer tastes or preferences • The prices of other goods • Consumer incomes • Number of consumers Chapter 2 Competitive Product Markets 7 • Expectations concerning future prices and incomes A host of other factors, like weather, may also influence the demand for particular goods-ice cream, for instance. A change in any of these determinants of demand will cause either an increase or a decrease in demand. • An increase in demand is an increase in the quantity demanded at each and every price. It is represented graphically by a rightward, or outward, shift in the demand cure. • A decrease in demand is a decrease in the quantity demanded at each and every price. It is represented graphically by a leftward, or inward, shift of the demand curve. Figure 2.2 illustrates the shifts in the demand curve that result from a change in one of the determinants of demand. The outward shift from D 1 to D 2 indicates an increase in demand: consumers now want more of a good at each and every price. For example, they want Q 3 instead of Q 2 tomatoes at price P 2 . Consumers are also willing to pay a higher price now for any quantity. For example, they will pay P 3 instead of P 2 for Q 2 tomatoes. The inward shift from D 1 to D 3 indicates a decrease in demand: consumers want less of a good at each and every price -- Q 1 instead of Q 2 tomatoes at price P 2 . And they are willing to pay less than before for any quantity -- P 1 instead of P 2 for Q 2 tomatoes. FIGURE 2.2 Shifts in the Demand Curve An increase in demand is represented by a rightward, outward, shift in the demand curve, from D 1 to D 2 . A decrease in demand is represented by a leftward, or inward, shift in the demand curve, from D 1 to D 3 . A change in a determinant of demand may be translated into an increase or decrease in market demand in numerous ways. An increase in market demand can be caused by: Chapter 2 Competitive Product Markets 8 An increase in consumers’ desire for the good. If people truly want the good more, they will buy more of the good at any given price or pay a higher price for any given quantity. An increase in the number of buyers. If people will buy more of the good at any given price, they will also pay a higher price for any given quantity. An increase in the price of substitute goods (which can be used in place of the good in question). If the price of oranges increases, the demand for grapefruit will increase. A decrease in the price of complement goods (which are used in conjunction with the good in question). If the price of stereo systems falls, the demand for records, tapes, and CDs will rise. Generally speaking (but not always), an increase in consumer incomes. An increase in people’s incomes may increase the demand for luxury goods, such as new cars. It may also decrease demand for low-quality goods (like hamburger) because people can now afford better-quality products (like steak). An expected increase in the future price of the good in question. If people expect the price of cars to rise faster than the prices of other goods, then (depending on exactly when they expect the increase) they may buy more cars now, thus avoiding the expected additional cost in the future. An expected increase in the future price of a substitute good. If people expect the price of oranges to fall in the future, then (depending on exactly when they expect the price decrease) they may reduce their current demand for grapefruit, so they can buy more oranges in the future. An expected increase in future incomes of buyers. College seniors’ demand for cars tends to increase as graduation approaches and they anticipate a rise in income. The determinants of a decrease in market demand are just the opposite: A decrease in consumers’ desire or taste for the good. A decrease in the number of buyers. A decrease in the price of substitute goods. An increase in the price of complement goods. Usually (but not always), a decrease in consumer incomes. An expected decrease in the future price of the good in question. An expected decrease in the future price of a substitute good. An expected decrease in the future incomes of buyers. Chapter 2 Competitive Product Markets 9 The Elements of Supply On the other side of the market are producers of goods. The average person thinks of supply as the quantity of a good producers are willing to sell. To economists, however, supply means something quite different. Supply is the assumed relationship between the quantity of a good producers are willing to offer during a given period and the price, everything else held constant. Generally, because additional costs tend to rise with expanded production, this relationship is presumed to be positive. Like demand, supply is not a given quantity—that is called quantity supplied. Rather it is a relationship between price and quantity. As the price of a good rises, producers are generally willing to offer a larger quantity. The reverse is equally true: as price decreases, so does quantity supplied. Like demand, supply can also be described in a table or a graph. Supply as a Table or a Graph Supply may be described as a schedule of the quantity producers will offer at various prices during a given period of time. Table 2.2 shows such a supply schedule. As the price of tomatoes goes up from zero to $11 a bushel, the quantity offered rises from zero of 110,000, reflecting the assumed positive relationship between price and quantity. Supply may also be thought of as a curve. If the quantity producers will offer is scaled on the horizontal axis of a graph and the price of the good is scaled on the vertical axis, the supply curve will slope upward to the right, reflecting the assumed positive relationship between price and quantity. In Figure 2.3, which was plotted from the data in Table 2.2, points a through l represent the price-quantity combinations A through L. Note how a change in the price causes a movement along the supply curve. 4 The Slope and Determinants of Supply The quantity producers will offer on the market depends on their production costs. Obviously the total cost of production will rise when more is produced because more resources will be required to expand output. The additional or marginal cost of each additional bushel produced also tends to rise as total output expands. In other words, it costs more to produce the second bushel of tomatoes than the first, and more to produce the third than the second. Firms will not expand their output unless they can cover their higher unit costs with a higher price. This is the reason the supply curve is thought to slope upward. Anything that affects production costs will influence supply and the position of the supply curve. Such factors, which are called determinants of supply, include: • Change in productivity due to a change in technology 4 Mathematically, the supply relationship may be stated as Q s = a + bP. Where Q s is the quantity supplied; a is the quantity producers will supply when the price is zero; b is the slope; and P is the price. Thus the supply function of tomatoes represented in Table 2.2 and Figure 2.3 may be written Q s = 0 + 10,000 P. . information, forcing competitors to reveal their plans to prospective buyers or sellers. The exchange of information can be seen clearly at auctions. Before. Chapter 2 Competitive Product Markets 2 the forces that will cause prices to change in the future and, therefore, the forces that affect their businesses’ bottom