CHAPTER 11 Firm Production under Idealized Competitive Conditions Economists understand by the term market, not any particular market place in which things are bought and sold, but the whole of any region in which buyers and sellers are in such free intercourse with one another that the prices of the same goods tend to equality, easily and quickly Augustin Cournot P receding chapters dealt separately with the two sides of markets, consumers and producers We devised graphic means of representing consumer preferences (the demand curve) and producer costs (average and marginal cost curves) This chapter brings demand and cost analysis together in order to examine the way in which individual firms react to consumer demand in competitive markets Our focus will be on a highly competitive market structure called perfect competition We will investigate an intriguing question: at the limit, how much can competitive markets contribute to consumer welfare? We will not attempt to give a full description of a real-world competitive market setting Because markets are so diverse, such a description would probably not be very useful Our aim is rather to devise a theoretical framework that will enable us to think about how markets work in general, as a constructive behavioral force Although our model cannot tell much that is specific about real-world markets, it will provide a basis for predicting the general direction of changes in market prices and output Through its analysis, we should gain a deeper understanding of the meaning of market efficiency Perfect competition is only one of four basic market structures The other three, and the detrimental effects of their restrictions on competition, are the subjects of following chapters The Four Market Structures Markets can be divided into four basic categories, based on the degree of competition that prevails within them that is, on how strenuously participants attempt to outdo, and avoid being outdone by, their rivals The most competitive of the four market structures is perfect competition Perfect Competition As we stressed much earlier in the book, perfect competition represents an ideal degree of competition Perfect competition can be recognized by the following characteristics: Chapter 11 Firm Production under Idealized Competitive Conditions There are many producers in the market, no one of which is large enough to affect the going market price for the product All producers are price takers, as opposed to price searchers or price makers (see the Perspective on the subject below) All producers sell a homogeneous product, meaning that the goods of one producer are indistinguishable from those of all others Consumers are fully knowledgeable about the prices charged by different producers and are totally indifferent as to which producer they buy from Producers enjoy complete freedom of entry into and exit from the market— that is, entry and exit costs are minimal, although not completely absent There are many consumers in the market, no one of whom is powerful enough to affect the market price of the product Like producers, consumers are price takers As we have seen before, the demand curve facing the individual perfect competitor is not the same as the demand curve faced by all producers The market demand curve slopes downward, as shown in Figure 11.1(a) The demand curve facing an individual producer -price taker is horizontal, as in Figure 11.1(b) This horizontal demand curve is perfectly elastic That is, the individual firm cannot raise its price even slightly above the going market price without losing all its customers to the numerous other producers in the market or to other producers waiting for an opportunity to enter the market On the other hand, the individual firm can sell all it wishes at the going market price Hence it has no reason to offer its output at a lower price The markets for wheat and for integrated computer circuits, or computer chips, are both good examples of real-world markets that come close to perfect competition Pure Monopoly Pure monopoly: A single seller of a product for which there are no close substitutes Protected from competition by barriers to entry into the market The barriers to entry into the monopolist’s market will be described in the next chapter For now, we will simply note that because the monopolistic firm does not have to worry about competitors undercutting its price, it can raise its price without fear that customers will move to other producers of the same product or similar products All the pure monopolist has to worry about is losing customers to producers of distantly related products Since the monopolist is the only producer of a particular good, the downward-sloping market demand curve [Figure 11.1(a)] is its individual demand curve Unlike the perfect competitor, the monopolistic firm can raise its price and sell less, or lower its price and sell more The critical task of the pure monopolist is to determine the one price-quantity combination of all price-quantity combinations on its demand curve that maximizes its profits In this sense the pure monopolist is a price searcher The best (but not perfect) realworld examples of a pure monopoly are regulated electric-power companies, which dominate in given geographical areas, and the government’s first-class postal system Chapter 11 Firm Production under Idealized Competitive Conditions FIGURE 11.1 Demand Curve Faced by Perfect Competitors The market demand for a product part (a) is always downward sloping The perfect competitor is on a horizontal, or perfectly elastic, demand curve [part (b)] It cannot raise its price above the market price even slightly without losing its customers to other producers Monopolistic Competition Monopolistic competition is a market composed of a number of producers whose products are differentiated and who face highly elastic, but not perfectly elastic, demand curves A monopolistically competitive market can be recognized by the following characteristics: There are a number of competitors, producing slightly different products Advertising and other forms of nonprice competition are prevalent Entry into the market is not barred but is restricted by modest entry costs, mainly overhead Because of the existence of close substitutes, customers can turn to other producers if a monopolistically competitive firm raises its price Because of brand loyalty, the monopolistic competitor’s demand curve still slopes downward; but it is fairly elastic [see Figure 11.2) The market for textbooks is a good example of monopolistic competition Most subjects are covered by two or three dozen textbooks, differing from one another in content, style of presentation, and design Chapter 11 Firm Production under Idealized Competitive Conditions PERSPECTIVE: Price Takers and Price Searchers Perfect competition is an extreme degree of competition, so much so that many students are understandably concerned about its relevance They often ask, “If there are few market structures that even closely approximate perfect competition, why bother to study it?” The question is a good one and not altogether easy to answer There are few markets that come close to having numerous producers of an identical product with complete freedom of entry and exit Markets for agricultural commodities and for stocks and bonds are probably the closet markets we have to perfect competition, but still the products are not always completely identical, and entry and exit costs abound in most markets Even wheat sold by a Kansas wheat farmer us not always viewed the same as wheat sold by a Texas wheat farmer How can sense be made of perfect competition? The answer is remarkably simple We know that under the conditions of competition specified, certain results follow We can logically (with the use of graphs and mathematics) derive them, and the results are developed in this and the following chapter One conclusion drawn is that in perfect competition each firm will extend production until the marginal cost of producing the last unit equals the price paid by the consumer That conclusion necessarily follows As we will see, it is mathematically valid The strict (extreme) assumptions about the nature of perfect competition assure that The demanding conditions for perfect competition are rarely met We nevertheless cannot conclude that under less demanding competitive conditions, competitive results would not be observed [see the Perspectives on contestable markets on page 240.) For example, it may be that the number of producers is not “numerous” that the products sold by all producers are not completely “identical,” and that there are costs to moving in and out of markets Nonetheless, individual producers may act as if the conditions of perfect competition are met Individual producers may still act as if they have no control over market price or that there are so many other actual or potential producers that it is best to think in terms of the other producers being numerous”—in which case many of the predicted results of perfect competition may be still observed in the less-than-perfect markets For these reasons, many economists often talk not about perfect competitors but about price takers (who may or may not fit exactly the description of perfect competitors) Price takers are sellers who not believe they can control the market price by varying their own production levels They simply observe the market price and either accept it (and produce accordingly, to the point where marginal cost and marginal revenue and price are equal) or reject it (and go into some other business) The price taker is someone who acts as if his or her demand curve is horizontal (perfectly elastic, more or less) He or she is therefore someone who assumes the marginal revenue on each unit sold is constant (and equal to the price)—and that the marginal revenue curve is horizontal and the same as the firm’s demand curve The price searcher stands in contrast to the price taker Price searchers are sellers who have some control over the market price Price searchers have monopoly power due to the fact that they can alter production and thereby market supply sufficiently to change the price The individual price searcher’s task is not simply to accept or reject the current market price, but (like the monopolist) to “search” through the various price-quantity combinations on his or her downward sloping demand curve with the intent upon maximizing profits As we will see in the following chapter, the marginal revenue and demand curves of the price searcher are no longer the same (Exactly where the monopolist’s marginal revenue curve lies in relation to the demand curve will be discussed in detail in the next chapter) Chapter 11 Firm Production under Idealized Competitive Conditions FIGURE 11.2 Demand Curve Faced by a Monopolistic Competitor Because the product sold by the monopolistically competitive firm is slightly different from the products sold by competing producers, the firm faces a highly elastic, but not perfectly elastic, demand curve Oligopoly An oligopoly is a market composed of only a handful of dominant producers—as few as two—whose pricing decisions are interdependent Oligopolists may produce either an identical product (like steel) or highly differentiated products (like automobiles) Generally the barriers to entry into the market are considerable, but the critical characteristic of oligopolistic firms is that their pricing decisions are interdependent That is, the pricing decisions of any one firm can substantially affect the sales of the others Therefore, each firm must monitor and respond to the pricing and production decisions of the other firms in the industry The importance of this characteristic will become clear in a following chapter Table 11.1 summaries the characteristics of the four market structures The Perfect Competitor’s Production Decision As we learned earlier, the market price in a perfectly competitive market is determined by the intersection of the supply and demand curves If the price is above the equilibrium price level, a surplus will develop forcing competitors to lower their prices If the price is below equilibrium, a shortage will emerge, pushing the price upward [see Figure 11.3(a)] Given a market price over which it has no control, how much will the individual perfect competitor produce? The Production Rule: MC = MR Suppose the price in the perfectly competitive market for computer chips $5 (P1 in Figure 11.3) For each individual competitor, the market price is given, that is, cannot be changed It must be either accepted or rejected If the firm rejects the price, however, it must shut down If it raises its price even slightly above the market level, its customers will move to other competitors.) Demand, then, is horizontal at $5 Chapter 11 Firm Production under Idealized Competitive Conditions Table 11.1 Characteristics of the Four Market Structures Freedom of Entry Very easy Type of Product Perfect competition Number of Firms Many Pure monopoly One Barred Single product Monopolistic competition Many Relatively easy Differentiated Oligopoly Few Difficult Either standardized or differentiated Homogeneous Example Wheat, Computers, and Gold Public utilities and Postal service Pens, Books, Paper, and Clothing Steel, Light bulbs, Cereal, and Autos _ The firm’s perfectly elastic horizontal demand curve is illustrated on the right side of Figure 11.3 This horizontal demand curve is also the firm’s marginal revenue curve, because marginal revenue is defined as the additional revenue acquired from selling one additional unit Because each computer chip can be sold at a constant price of $5, the additional, or marginal, revenue acquired from selling an additional unit must be constant at $5 Because profit equals total revenue minus total cost (profit = TR = TC), the profitmaximizing firm will produce any unit for which marginal revenue exceeds marginal cost Thus the profit-maximizing firm in Figure 11.3(b) will produce and sell q1 units, the quantity at which marginal revenue equals marginal cost (MR = MC) Up to q1 , marginal revenue is greater than marginal cost Beyond q1 , all additional computer chips are unprofitable: the additional cost of producing them is greater than the additional revenue acquired [with the small “q” being used to remind you that the output individual producer in Figure 11.3(b) is a small fraction of the output for the market, designated by a capital “Q” in Figure 11.3 (a)] Changes in Market Price The perfectly competitive firm produces where MC = MR, both of which are equal to price Thus the amount the firm produces depends on market price As long as market demand remains constant, the individual firm’s demand, and its price, will also remain constant If market demand and price increase, however, the individual firm’s demand and price will also increase Chapter 11 Firm Production under Idealized Competitive Conditions FIGURE 11.3 The Perfect Competitor’s Production Decision The perfect competitor’s price is determined by market supply and demand [part (a)] As long as marginal revenue (MR), which equals market price, exceeds marginal cost (MC), the perfect competitor will expand production [part (b)] The profit-maximizing production level is the point at which marginal cost equals marginal revenue (price) FIGURE 11.4 Change in the Perfect Competitor’s Market Price If the market demand rises from D1 to D3 [part (a)], the price will rise with it, from P1 to P3 As a result, the perfectly competitive firm’s demand curve will rise, from d1 to d3 [part (b)] Chapter 11 Firm Production under Idealized Competitive Conditions Figure 11.4 (above) shows how the shift occurs The original market demand of D1 leads to a market price of P1 [part (a)], which is translated into the individual firm’s demand, d1 [part (b)] The firm maximizes profit by equating marginal cost with marginal revenue, which is equal to d1 , at an output level of q1 An increase in market demand to D2 leads to the higher price P2 and a higher individual demand curve, d2 At this higher price, which equals marginal revenue, the perfect competitor can support a higher marginal cost The firm will expand production from q1 to q2 In the same way, an even greater market demand, D3 , will lead to even higher output, q3 , by the individual competitor Why does the market supply curve slope upward and to the right? The answer lies in the upward-sloping marginal cost curves confronted by individual firms (The market supply curve is obtained by horizontally adding the supply curves of individual firms.) The individual firm’s marginal cost curves slope upward because of diminishing (marginal) returns, a technological fact of the production process Maximizing Short-Run Profits Can perfect competitors make an economic profit? The answer is yes, at least in the short run To see this point, we must incorporate the average and marginal cost curves developed in the last chapter into our graph of the perfect competitor’s demand curve, as in Figure 11.5(b) [Figure 11.5(a) shows the market supply and demand curves.) As before, the producer maximizes profits by equating marginal cost with price, rather than by looking at average cost That is exactly what the perfect competitor does The firm produces q2 computer chips because that is the point at which marginal revenue curve (which equals the firm’s demand curve crosses the marginal cost curve At that intersection, marginal revenue of the last unit sold equals its marginal cost If less were produced that q1 , the marginal cost would be less than the marginal revenue, and profits would be lost Similarly, by producing anything more than q2 , the firm incurs more additional costs (as indicated by the marginal To prove this statement, first we note that TR = PQ Then we define short-run total cost to be a function of output: SRTC = C (Q) Next, we define profits π to be π = TR − SRTC = PQ − C( Q) Differentiating with respect to Q and equating with 0, we then obtain dπ dC( Q) = P− =0 dQ dQ dC(Q) P= dQ dC( Q) Since = SRMC, profits are maximized when SRMC = P dQ Chapter 11 Firm Production under Idealized Competitive Conditions cost curve) than it receives in additional revenue (as indicated by the demand curve, which beyond q2 is below the MC curve) At q2 (and anywhere else), the firm’s profit equals total revenue minus total cost (TR – TC) To find total revenue, we multiply the price, P1 (which also equals average revenue) by the quantity produced, q2 (TR = P1q2 ) Graphically, total revenue is equal to the area of the rectangle bounded by the price and quantity, or 0P1aq2 Similarly, total cost can be found by multiplying the average total cost of production (ATC) by the quantity produced The ATC curve shows us that the average total cost of producing q2 computer chips is ATC1 Therefore total cost is ATC1q2 , or the rectangular area bounded by 0ATC1 bq2 The profits of the company are therefore P1q2 – ATC1 q2 , which is the same, mathematically, as q2 (P1 – ATC1 ) This quantity corresponds to the area representing total revenue, OP1 aq2 , minus the area representing total cost, 0ATC1 bq2 Profit is the shaded rectangle bounded by ATC1 P1 ab FIGURE 11.5 The Profit-Maximizing Perfect Competitor The perfect competitor’s demand curve is established by the market-clearing price [part (a)] The profit-maximizing perfect competitor will extend production up to the point where marginal cost equals marginal revenue (price), or point a in part (b) At that output level—q2—the firm will earn a short-run economic profit equal to the shaded area ATC P1ab If the perfect competitor were to minimize average total cost, it would produce only q , losing profits equal to the darker shaded area dca in the process The perfect competitor does not seek to produce the quantity that results in the lowest average total cost That quantity, q1 , is defined by the intersection of the marginal cost curve and the average total cost curve If it produced only q1 , the firm would lose out on some of its profits, shown by the darker shaded area dca (Suppose the firm is producing at q1 If it expands production to q2 , it will generate P1 times q2 – q1 in extra revenue (price times the additional units sold), an amount represented graphically by the area q1 daq2 ) Chapter 11 Firm Production under Idealized Competitive Conditions Naturally, profit-maximizing firms will attempt to minimize their costs of production That does not mean they will produce at the point of minimum average total cost Instead, the will try to employ the most efficient technology available and to minimize their payments for resources That is they will attempt to keep their cost curves as low as possible But given those curves, the firm will produce where MC = MR, not where ATC is at its lowest level Managers who cannot distinguish between those two objectives will probably operate their businesses on a less profitable basis than they might—and will risk being run out of business Minimizing Short-Run Losses In the foregoing analysis the market-determined price was higher than the firm’s average total cost, allowing it to make a profit Perfect competitors are not guaranteed profits, however The market price may not be high enough for the firm to make a profit Suppose, for example, that the market price is P1 , below the firm’s average total cost curve [see Figure 11.6) Should the firm still produce where marginal cost equals marginal revenue (price)? The answer, for the short run, is yes As long as the firm can cover its variable cost, it should produce q1 computer chips FIGURE 11.6 The Loss-Minimizing Perfect Competitor The market-clearing price [part (a)] establishes the perfect competitor’s demand curve [part (b)] Because the price is below the average total cost curve, this firm is losing money As long as the price is above the low point of the average variable cost curve, however, the firm should minimize its short-run losses by continuing to produce where marginal cost equals marginal revenue [price or point b in part (b)] This perfect competitor should produce q units, incurring losses equal to the shaded area P1 ATC ab (The alternative would be to shut down, in which case the firm would lose all its fixed costs.) It is true that the firm will lose money Its total revenues are only P1q1 , or the area bounded y 0P1 bq1 , whereas its total costs are ATC1 q1 , or the area 0ATC1 aq1 , whereas its total Chapter 11 Firm Production under Idealized Competitive Conditions The Long-Run Effect of Short-Run Profits and Losses When profits encourage new firms to enter an industry and existing firms to expand, the result is an increase in market supply, a decrease in market price, and a decrease in the profitability of individual firms For example, in Figure 11.7(a), the existence of economic profits in the computer chip market means that investors can earn more in that industry than in some others Some investors will move their resources to the computer chip industry Because the number of producers increases, the supply curve shifts outward, expanding total production from Q1 to Q2 and depressing the market price from P2 to P1 The expansion of industry supply and the resulting reduction in market price make the computer chip business less profitable for individual firms The lower market price is reflected in a downward shift of the firm’s horizontal demand curve, from d1 to d2 [see Figure 11.7(b)] The individual firm reduces it output from q2 to q1 , the intersection of the new marginal revenue (price/demand) curve with the marginal cost curve Note that q1 is also the low point of the average total cost curve Here price equals average total cost, meaning that economic profit is zero The firm is making just enough to cover its opportunity and risk costs, but no more Losses have the opposite effect on long-run industry supply In the long run, firms that are losing money will move out of the industry, because their resources can be employed more profitably elsewhere When firms drop out of the industry, supply contracts and total FIGURE 11.7 The Long-Run Effects of Short-Run Profits If perfect competitors are making short-run profits, other producers will enter the market, increasing the market supply from S to S and lowering the market price, from P2 to P1 part (a) The individual firm’s demand curve, which is determined by market price will shift down, from d to d [part (b)] The firm will reduce its output from q to q , the new intersection of marginal revenue (price) and marginal cost Long-run equilibrium will be achieved when the price falls to the low point of the firm’s average total cost curve, eliminating economic profit [price P1 in (b)] Chapter 11 Firm Production under Idealized Competitive Conditions production falls, from Q2 to Q1 in Figure 11.8(a) As a result, the price of the product rises, permitting some firms to break even and stay in the business Long-run equilibrium occurs when the price reaches P2 , where the individual firm’s demand curve is tangent to the low point of the average total cost curve [Figure 11.8(b)] The output of each remaining individual firm expands (from q1 to q2 ) to take up the slack left by the firms that have withdrawn Again price and average total cost are equal, and economic profit is zero FIGURE 11.8 The Long-Run Effects of Short-Run Losses If perfect competitors are suffering short-run losses, some firms will leave the industry causing the market supply to shift back from S to S and the price to rise, from P1 to P2 part (a) The individual firm’s demand curve will shift up with price, from d to d [part (b)] The firm will expand from q to q , and equilibrium will be reached when price equals the low point of average total cost P2 , eliminating the firm’s short-run losses The Effect of Economies of Scale In the long run, competition forces firms to take advantage of economies of scale, if they exist If expanding the use of resources reduces costs, the perfect competitor must expand Otherwise, other firms will expand their scale of operation, increasing market supply and forcing the market price down Any firm that does not expand its scale will be caught with a cost structure that is higher than the market price In addition to mere self-preservation, the firm also has a profit incentive for expansion If it expands before other firms, its lower average total cost will allow it to make greater profits for a short period of time Consider Figure 11.9, for instance Initially the market is in short-run equilibrium at a price of P2 [part (a)] The individual firm is on cost scale ATC1 , producing q1 chips and breaking even [part (b)] If the firm expands its scale of operation and produces where its demand curve d1 intersects the long-run marginal cost curve, it will make a profit equal graphically to the shaded area ATC1 P2 ab That is the firm’s incentive for expansion Chapter 11 Firm Production under Idealized Competitive Conditions FIGURE 11.9 The Long-Run Effects of Economies of Scale If the market is in equilibrium at price P1 in part (a) and the individual firm is producing q units on short -run average total cost curve ATC [part (b)], firms will be just breaking even Because of the profit potential represented by the shaded area ATC P2 ab, firms can be expected to expand production to q , where the long-run marginal cost curve intersects the demand curve (d ) As they expand production to take advantage of economies of scale, however, supply will expand from S to S in part (a), pushing the market price down toward P1 , the low point of the long-run average total cost curve (LRAC) Economic profit will fall to zero Because of rising diseconomies of scale, firms will not expand further If the firm does not expand and take advantage of these economies, some other firm surely will Then any firm still producing on scale ATC1 will lose money For when the market supply expands the price will tumble toward P1 , the point at which the long-run average total cost curve (and the short-run curve ATCm) are at a minimum, and both industry and firm profits are zero Because of rising diseconomies of scale, firms will not be able to expand further Any firm that tries to produce on a smaller or larger scale—for example, ATC2 or ATC3 will occur average total costs higher than the market price and will lose money Ultimately it will be driven out of the market or forced to expand or contract its scale The Efficiency of Perfect Competition: A Critique Our discussion of perfect competition has been highly theoretical In real life, the competitive market system is not as efficient as the analysis may suggest Several aspects of the competitive market deserve further comment from this perspective The Tendency Toward Equilibrium Market forces are stabilizing: they tend to push the market toward one central point of equilibrium To that extent the market is predictable, and to that extent it contributes to economic and social stability In the real world price does not always move as smoothly toward equilibrium as it appears to in supply and demand models The smooth, direct Chapter 11 Firm Production under Idealized Competitive Conditions move to equilibrium may happen in markets where all participants, both buyers and sellers, know exactly what everyone else is doing Often, however, market participants have only imperfect knowledge of what others are going to do, for one function of the market is to generate the pricing and output information people need to interact with one another In a world of imperfect information, then, prices may not and probably will not move directly toward equilibrium Those who compete in the market will continually grope for the “best” price, from their own individual perspectives At times sellers will produce too little and reap unusually high profits This process of groping toward equilibrium can be represented graphically by a supply and demand “cobweb” [see Figure 11.10) Most producers must plan their production at least several months ahead on the basis of prices received today or during the past production period Farmers, for instance, may plant for summer harvest on the basis of the previous summer’s prices Suppose farmers got price P1 for a bushel of wheat last year Their planning supply curve, S, will encourage them to work for a harvest of only Q1 bushels this year Given that limited output and the rather high demand at price P1 , however, the price farmers actually receive is P4 The price of P4 in turn induces farmers to plan for a much larger production level, Q3 , the following year The market will not clear for Q3 bushels, however, until the price falls to P2 The next year farmers plan for a price of P2 and reduce their production to Q2 —which causes the price to rise to P3 As you can see from the graph, instead of moving in a straight line, the market moves toward the intersection of supply and demand in a web-like pattern FIGURE 11.10 Supply and Demand Cobweb Markets not always move smoothly toward equilibrium If current production decisions are based on past prices, price may adjust to supply in the cobweb pattern shown here Having received price P1 in the past, farmers will plan to supply only Q1 bushels of wheat That amount will not meet market demand, so the price will rise to P4 —inducing farmers to plan for a harvest of Q3 bushels At price P4 , however, Q3 bushels will not clear the market The price will fall to P2 , encouraging farmers to cut production back to Q2 Only after several tries many farmers find the equilibrium pricequantity combination Surpluses and Shortages Some critics complain that the market system creates wasteful surpluses and shortages Although all resources are limited in quantity, a true market shortage can exist only if the going price is below equilibrium Thus shortages can be eliminated by a price increase Chapter 11 Firm Production under Idealized Competitive Conditions How much of an increase, theory alone cannot say We know, however, that market forces, if allowed free play, will work to boost the price and eliminate the shortage That means, if course, that people of limited financial resources will be eliminated from the market—an enduring concern that motivates many government efforts to legislate market conditions Similarly, all surpluses exist because the going price is above equilibrium Competition will reduce the price, eliminating the surplus In the process, of course, some firms will be driver out of the market and into other, more productive activities Others will be unable to keep their employees working full-time A frequent criticism of the market system is that when this happens, workers have difficulty finding employment in other lines of production Part of the problem, however, is that labor contracts, community custom, or minimum wage laws prevent wages from adjusting downward If government controls prices—that is, if prices are not permitted to respond to market conditions-—surpluses and shortages will persist Marginal Benefit Versus Marginal Cost Time lags, surpluses, and shortages notwithstanding, the competitive market can produce efficient results in one important sense That is that the marginal benefit of the last unit produced equals its marginal cost (MB = MC) In Figure 11.11(a), for every computer chip up to Q1 , consumers are willing to pay a price (as indicated by the demand curve, D) greater than its marginal cost (as indicated by the industry supply curve, S) The difference between the price consumers are willing to pay—an objective indication of the product’s marginal benefits—and the marginal cost of production is a kind of surplus, or net gain received from the production of each unit The net gain is composed of two surpluses, consumer surplus and producer surplus Consumer surplus is the difference between the total willingness of consumers to pay for a good and the total amount actually spent In Figure 11.11(a) consumer surplus is the triangular area below the demand curve and above the dotted price line, P1 Producer surplus is the difference between the minimum total revenue necessary to induce producers to supply Q1 units of output and the actual total revenue received from selling that output In Figure 11.11(a), producer surplus is the triangular area above the supply curve and below the dotted price line, P1 By producing Q1 units, the industry exploits all potential gains from production, shown graphically by the shaded triangular area in the figure That net gain is brought about by the price that is charged, P1 —a price that induces individual firms to produce where the marginal cost of production equals the price, which is also equal to consumers’ marginal benefit The marginal cost of production for each individual firm is also P1 , a fact that results in the production of Q1 units at the minimum total cost Parts (b) and (c) show the cost curves of two firms, X and Y In competitive equilibrium, firm X produces qx , units Suppose that the market output were distributed between the firms differently Suppose, for example, that firm X produced one computer chip less than qx To maintain a constant market output of Q1 , firm Y (or some other firm) would then have to expand production by one unit The additional chip would force firm Y up its marginal cost curve To Y, the marginal cost of the additional chip is greater than P1 , greater than X’s marginal cost to produce it Competition Chapter 11 Firm Production under Idealized Competitive Conditions forces firms to produce at a cost-effective output level and therefore minimizes the cost of producing at any given level of output Perfectly competitive markets are attractive for another reason In the long run, competition forces each firm to produce at the low point of its average total cost curve Firms must either produce at that point, achieving whatever economies of scale are available, or get out of the market, leaving production to some other firm that will minimize average total cost _ FIGURE 11.11 The Efficiency of the Competitive Market Perfectly competitive markets are efficient in the sense that they equate marginal benefit [shown by the demand curve in part (a)] with marginal cost (shown by the supply curve) At the market output level, Q1 , the marginal benefit of the last unit produced equals the marginal cost of production The gains generated by the production of Q1 units—that is , the difference between cost and benefits—are shown by the shaded are in part (a) The perfectly competitive market is also efficient in the sense that the marginal cost of production, P1 , is the same for all firms [parts (b) and (c)] If firm X were to produce fewer than its efficient number of units, q x, firm Y would have to produce more than its efficient number, q y , to meet market demand Firm Y would be pushed up its marginal cost curve, to the point where the cost of the last unit exceeds its benefits But competition forces the two firms to produce to exactly the point where marginal cost equals marginal benefit, thus minimizing the cost of production Chapter 11 Firm Production under Idealized Competitive Conditions Critics stress, however, that supply is based only on the costs firms bear privately External costs like air, noise, and water pollution are not counted as part of the cost of production If the external costs of pollution were counted, the firm’s supply curve would be lower, S2 instead of S1 in Figure 11.12 If producers and consumers had to pay all the costs of production, only Q1 units would be bought In this sense, competition leads to overproduction of Q2 – Q1 units The cost of producing these Q2 – Q1 chips is the area under the supply curve between Q1 and Q2 , Q1 abQ2 The benefit to consumers is the area under the demand curve, or the area Q1 acQ2 The extent to which the cost of overproduction exceeds the benefits to consumers is shown by the shaded triangular area abc _ FIGURE 11.12 Inefficiency Caused by External Costs If external costs equal to the vertical distance bc are not counted as costs of production, s upply will be artificially high at S , and firms will overproduce by Q2 – Q1 units The inefficiency, or welfare loss, form such overproduction is shown by the shaded area abc, the amount by which the total cost of producing Q2 – Q1 units (shown by curve S ) exceeds their total benefits (shown by the demand curve) Critics of the market system stress also that its cost efficiencies are achieved within a specific distribution of resources of wealth, one that depends on the existing distribution of property rights The distribution of economic power inherent in these property rights, they argue, has no particular ethical or moral significance Finally, critics of the market system argue that most real-world markets are not perfectly competitive Actual markets are not inhabited by numerous firms producing standard commodities that can be easily duplicated by anyone who would like to enter the market Indeed, many markets are inhabited by a few large, powerful firms that not take price as a given Many firms either are monopolies or possess a high degree of monopoly power Demanders and suppliers are rarely as well informed as the model suggests The model of perfect competition was never meant to represent all or even most markets It is merely one of several means economists use to think about markets and the consequences of changes in market conditions and government policy Critics of the market system stress also that its cost efficiencies are achieved within a specific distribution of resources or wealth, one that depends on the existing distribution of property rights The distribution of economic power inherent in these property rights, they argue, has no particular ethical or moral significance Chapter 11 Firm Production under Idealized Competitive Conditions Contestable Markets One of the most important developments in the study of markets is the theory of contestable markets.2 The contestable market model stresses the importance of potential rather than actual competitors in a market A market is deemed to be contestable if entry and exit are relatively easy A market is perfectly contestable if entry is absolutely free and exit is costless Free entry has a particular meaning in the theory of contestable markets; it means that new firms entering an industry are not at any cost disadvantage compared to existing firms in the industry In other words, latecomers suffer no cost handicaps Costless exit means that firms can leave the industry at any time and can recoup all costs incurred by entry A contestable market, then, is marked by ease of entry and exit and in that respect is similar to a perfectly competitive market Like a perfectly competitive market, a contestable market will be characterized by zero economic profits in the long run For a contestable market, however, we not need a large number of firms and a homogeneous product Indeed, multiproduct firms are possible in contestable markets A contestable market may have only two or three firms operating in it Moreover, those firms produce at rates of output where price is equal to marginal cost What brings about this result? Why firms in contestable markets not produce and price at the monopoly equilibrium? The reason is entry and exit If price is not equal to marginal cost, profit opportunities exist and new firms will quickly enter the market, causing existing firms to make losses The potential competitors force the existing firms to produce where price equals marginal cost A firm in a contestable market is always open to hit and run attacks from its potential competitors They will therefore be forced to produce and sell at an output where price equals marginal cost and economic profits are zero Any attempt to exploit market power will bring about entry into the market and the dissipation of all profits The firms in the contestable market will be forced to operate as it they were in perfectly competitive markets A contestable market is depicted in Figure 11.14 Note that although only three firms are in the industry, they all produce where price equals marginal and average cost For the industry as a whole, price is equal to the minimum on the long-run average total cost curve Each firm produces one-third (q) of total industry output (3q) Production at an efficient rate of output and marginal cost pricing, then, not require the atomistic markets of the perfectly competitive model A perfectly contestable market will What industries might this model fit? The air travel industry is one candidate Many major markets are served by only two or three airlines Yet if an airline with a dominant position in a particular regional market attempted to set price well above costs, entry would quickly follow Airplanes can be shifted from one market or use to another with ease New The basic model of a contestable market is presented in William J Baumol, “Contestable Markets: An Uprising in the Theory of Industry Structure,” American Economic Review, 72 (March 1982), 1-15 For a critical analysis of the model, see William G Shepherd, “‘Contestability’ vs Competition,” American Economic Review 74 (September 1984), pp 572-587 Chapter 11 Firm Production under Idealized Competitive Conditions entrants not appear to be at a cost disadvantage relative to existing firms If the conditions for a contestable market were indeed met, then we would expect the air travel industry to be characterized by marginal cost pricing and zero economic profits It is always difficult to determine whether or not price is equal to marginal cost; one indication that contestability characterizes the air travel industry is that prices not appear to be higher in markets with fewer actual competitors The zero-profit outcome also describes the air travel industry reasonable well _ FIGURE 11.14 A Contestable Market The market is composed of three firms, each producing output q*, which minimizes average costs Total industry output is Q* = 3q* Any attempt by the three firms to reduce output and increase market price will lead to entry by new firms and the dissipation of profits MANAGER’S CORNER: When Workers Would Want Their Bosses to Cut Their Pay In trying to manage a firm’s production and cost properly, managers want to cater to many (not all) of their workers’ wishes What is more obvious than the desire of workers for higher salaries and wages? Certainly no sane person would deny that all workers would rather be paid more money rather than less, everything else equal But everything else is seldom equal For example, while workers may rather take home bigger paychecks with the work being held equal, they not necessarily want a higher wage if it requires less pleasant or more difficult responsibilities.3 But even for the same work, workers may prefer to be paid less money Indeed, workers are better off because employers are constantly looking for, and succeeding in finding, ways to pay them less This is a point you very likely haven’t seen covered in your human resource studies As explained in an earlier chapter, despite what they may say, most young and inexperienced MBA graduates would not want a job paying $200,000 immediately upon graduation Such an employee would have to contribute at least $200,000 to firm revenues, which he or she, without experience, is not likely to be able to The expected value of a job with a much lower salary is likely to be higher, given the much higher probability of the new graduate keeping it ... presentation, and design Chapter 11 Firm Production under Idealized Competitive Conditions PERSPECTIVE: Price Takers and Price Searchers Perfect competition is an extreme degree of competition, so much... curve will be discussed in detail in the next chapter) Chapter 11 Firm Production under Idealized Competitive Conditions FIGURE 11. 2 Demand Curve Faced by a Monopolistic Competitor... horizontal at $5 Chapter 11 Firm Production under Idealized Competitive Conditions Table 11. 1 Characteristics of the Four Market Structures Freedom of Entry Very easy Type of Product Perfect competition