Exploring Economics - 4e - Chapter 13.pdf

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CHAPTER
F IRMS IN P ERFECTLY
C OMPETITIVE M ARKETS
13
F IRMS IN P ERFECTLY
C OMPETITIVE M ARKETS
13.1
The Four Market Structures
13.4 Short-Run Profits and Losses
13.2An Individual Price Taker's
Demand Curve
13.5 Long-Run Equilibrium
13.6 Long-Run Supply
13.3
Profit Maximization
I
n the previous chapter we discussed the costs of
production. In this chapter, we put the cost of
production together with demand and the mar-
ginal analysis we learned in earlier chapters to
see how a firm must answer two critical questions:
What price should we charge for the goods and
services we sell, and how much should we pro-
duce? The answers to these two questions will
depend on the market structure.
The behavior of firms will depend on the
number of firms in the market, the ease with which
firms can enter and exit the market, and the ability
of firms to differentiate their products from those
of other firms. There is no typical industry. An
industry might include one firm that dominates the
market, or it might consist of thousands of smaller
firms that each produce a small fraction of the
market supply. Between these two end points are
many other industries. However, because we cannot
examine each industry individually, we break them
into four main categories: perfect competition,
monopoly, monopolistic competition, and oligopoly.
In a perfectly competitive market, the market
price is the critical piece of information that a firm
needs to know, a firm in a perfectly competitive
market can sell all it wants at the market price. A
firm in a perfectly competitive market is said to be
a price taker, because it cannot appreciably affect
the market price for its output or the market price
for its inputs. For example, suppose a Washington
apple grower decides that he wants to get out of
the family business and go to work for Microsoft.
Because he may be one of 50,000 apple growers in
the United States, his decision will not appreciably
change the price of the apples, the production of
apples, or the price of inputs.
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Households, Firms, and Market Structure
MODULE 3
SECTION
13.1
The Four Market Structures
What are the four market structures?
What is a price taker?
What are the characteristics of a firm in a
perfectly competitive market?
Economists have identified four market structures in
which firms operate: perfect competition, monopolistic
competition, oligopoly, and monopoly. Certain key
characteristics distinguish each structure or environ-
ment from the other structures. In practice, it is some-
times difficult to decide precisely which structure a given
firm or industry most appropriately fits, because the
dividing line between the structures is not crystal clear.
In the next few paragraphs, we will briefly summarize
the major characteristics of each market structure.
may involve a stan-
dardized product (such
as steel, aluminum, or
crude oil) or a differ-
entiated one (such as
automobiles, breakfast
cereals, refrigerators,
or TVs).
oligopoly
a market structure with only a few
sellers offering similar or identical
products
MONOPOLY
At the other end of the continuum of market environ-
ments is monopoly. In this market structure, one firm
produces a good or
service that has no close
substitutes, and poten-
tial entrants into the
market must overcome
significant barriers. The
monopolists’ product is
unique, there are no close substitutes. Examples of
monopoly include public utilities (electric, water, and
natural gas suppliers) and first class mail delivery by
the U.S. Postal Service.
Economists often distinguish the perfectly com-
petitive market from the imperfectly competitive
markets of monopolistic competition, oligopoly, and
monopoly. The differences between these markets
will become clearer as we look at them separately in
the chapters to come. Because we will often compare
perfect competition to the other market structures,
let us start by taking a closer look at perfectly com-
petitive markets.
Exhibit 1 summarizes the characteristics of the
four market structures in which firms operate: per-
fect competition, monopolistic competition, oligop-
oly, and monopoly. Each structure or environment
has certain key characteristics that distinguish it from
the other structures. In practice, it is sometimes diffi-
cult to decide precisely which structure a given firm
or industry most appropriately fits, because the
dividing line between the structures is not always
crystal clear.
PERFECT COMPETITION
A competitive market is a market situation character-
ized by a large number of buyers and sellers. Firms in
a perfectly competitive market sell homogeneous
or standardized products like wheat or apples. New
firms can easily enter the market.
monopoly
the single supplier of a product
that has no close substitute
MONOPOLISTIC COMPETITION
Monopolistic competition falls between perfect
competition and monopoly. Monopolistic competi-
tion is a market struc-
ture in which firms
have both an element
of competition and an
element of monopoly
power. In this market
structure, there are a
relatively large number
of sellers producing dif-
ferentiated products
(restaurants, meals,
cloths, books). There is
considerable non price
competition as firms try to distinguish their product
from others. In this market structure, entry and exit is
very easy.
perfectly competitive
market
a market with many buyers and sell-
ers selling homogeneous goods, easy
market entry and exit, and no firm
able to affect the market price
monopolistic
competition
a market structure with many firms
selling differentiated products
OLIGOPOLY
Oligopoly exists when a few firms produce similar
or identical goods. The oligopolist is very con-
scious of the actions of competing firms. Oligopoly
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Firms in Perfectly Competitive Markets
CHAPTER 13
SECTION 13.1
E XHIBIT 1
Characteristics of the Four Major Market Structures
Perfect
Monopolistic
Characteristic
Competition
Competition
Oligopoly
Monopoly
Number of firms
Very many
Many
A few
One
Barriers to entry or
No substantial ones
Minor barriers
Considerable barriers
Extremely great
exit from industry
Type of product
Homogeneous
Differentiated
Homogeneous or
Unique, no close
differentiated
substitute
Key characteristic
Firms are price takers
Product differentiation
Mutual
Only one firm
interdependence
Examples
Agriculture
Retail trade, restaurants
Steel, automobiles,
Local utilities
household appliances
competitive firms are called price takers: They must
take the price given by the market because their
influence on price is insignificant. If the price of
apples in the apple market is $2 a pound, then indi-
vidual apple farmers will receive $2 a pound for their
apples. Similarly, no single buyer of apples can
influence the price of apples, because each buyer pur-
chases only a small amount of the apples traded. We
will see how this relationship works in more detail in
Section 13.2.
Identical (Homogeneous) Products
Consumers believe that all firms in perfectly competi-
tive markets sell identical (or homogeneous) products .
For example, in the wheat market, it is not possible to
determine any significant and consistent qualitative
differences in the wheat produced by different farm-
ers. Wheat produced by Farmer Jones looks, feels,
smells, and tastes like that produced by Farmer Smith.
In short, a bushel of wheat is a bushel of wheat. The
products of all the firms are considered to be perfect
substitutes.
Can the owner of this orchard charge a noticeably higher
price for apples of similar quality to those sold at the orchard
down the road? What if she charges a lower price for apples
of similar quality? How many apples can she sell at the
market price?
A PERFECTLY COMPETITIVE MARKET
This chapter examines perfect competition, a market
structure characterized by (1) many buyers and sellers,
(2) identical (homogeneous) products, and (3) easy
market entry and exit. Let’s examine these characteris-
tics in greater detail.
Easy Entry and Exit
Product markets characterized by perfect competi-
tion have no significant barriers to entry or exit.
Therefore it is fairly easy for entrepreneurs to
become suppliers of the product or, if they are
already producers, to stop supplying the product.
“Fairly easy” does not mean that any person on the
street can instantly enter the business but rather that
the financial, legal, educational, and other barriers to
entering the business are modest, enabling large
numbers of people to overcome the barriers and
enter the business if they so desire in any given
Many Buyers and Sellers
In a perfectly competitive market, there are many
buyers and sellers; perhaps thousands or conceivably
millions. Because each firm is so small in relation to
the industry, its production decisions have no impact
on the market—each regards price as something over
which it has little control. For this reason, perfectly
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Households, Firms, and Market Structure
MODULE 3
period. If buyers can easily switch from one seller to
another and sellers can easily enter or exit the indus-
try, then they have met the perfectly competitive con-
dition of easy entry and exit. Because of this easy
market entry, perfectly competitive markets generally
consist of a large number of small suppliers.
A perfectly competitive market is approximated
most closely in highly organized markets for securities
and agricultural commodities, such as the New York
Stock Exchange or the Chicago Board of Trade. Wheat,
corn, soybeans, cotton, and many other agricultural
products are sold in perfectly competitive markets.
Although all the criteria for a perfectly competitive
market are rarely met, a number of markets come close
to satisfying them. Even when all the assumptions don’t
hold, it is important to note that studying the model of
perfect competition is useful because many markets
resemble perfect competition—that is, markets in
which firms face highly elastic (flat) demand curves and
relatively easy entry and exit. The model also gives us
a standard of comparison. In other words, we can
make comparisons with the perfectly competitive
model to help us evaluate what is going on in the real
world.
At the Chicago Board of Trade (CBOT), prices are set by thou-
sands of buyers interacting with thousands of sellers. The
goods in question are typically standardized (e.g., grade A
winter wheat), and information is readily available. Every
buyer and seller in the market knows the price, the quantity,
and the quality of the wheat. Transaction costs are negligible.
For example, if a news story breaks on an infestation in the
cotton crop, the price of cotton will rise immediately. CBOT
price information is used to determine the value of a particu-
lar commodity all over the world.
SECTION *
CHECK
1.
The four main market structures are perfect competition, monopolistic competition, oligopoly, and
monopoly.
2.
A perfectly competitive market is characterized by many buyers and sellers, an identical (homogeneous)
product, and easy market entry and exit.
3.
Consumers believe that all firms in perfectly competitive markets sell virtually identical (homogeneous)
products. The products of all firms are considered to be perfect substitutes.
4.
In markets with so many buyers and so many sellers, neither buyers nor sellers have any control over price in
perfect competition. They must take the going price and hence are called price takers.
5.
Firms in a perfectly competitive markets have no significant barriers to entry. That is, the barriers are
significantly modest, so that many sellers can enter or exit the industry.
1.
Why do firms in perfectly competitive markets involve homogeneous goods?
2.
Why does the absence of significant barriers to entry tend to result in a large number of suppliers?
3.
Why does the fact that perfectly competitive firms are small relative to the market make them price
takers?
4.
Why is the market for used furniture unlikely to be perfectly competitive?
5.
How is pure monopoly the opposite of perfect competition?
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Firms in Perfectly Competitive Markets
CHAPTER 13
SECTION
13.2 An Individual Price Taker’s
Demand Curve
Why won’t individual price takers raise or
lower their prices?
Will the position of individual price takers’
demand curves change when market price
changes?
Can individual price takers sell all they
want at the market price?
AN INDIVIDUAL FIRM’S DEMAND CURVE
Likewise, in a perfectly competitive market,
individual sellers can change their outputs, and it
will not alter the market price. The large number of
sellers who are selling identical products make this
situation possible. Each producer provides such a
small fraction of the total supply that a change in the
amount he offers does not have a noticeable effect
on market equilibrium price. In a perfectly competi-
tive market, then, an individual firm can sell as much
as it wishes to place on the market at the prevailing
price; the demand, as seen by the seller, is perfectly
elastic.
It is easy to construct the demand curve for an
individual seller in a perfectly competitive market.
Remember, she won’t charge more than the market
price because no one will buy it, and she won’t
charge less because she can sell all she wants at the
market price. Thus, the farmer’s demand curve is
Perfectly competitive firms are price takers; that is,
they must sell at the market-determined price, where
the market price and
output are determined
by the intersection of
the market supply and
demand curves, as seen
in Exhibit 1(b).
Individual wheat farm-
ers know that they
cannot dispose of their wheat at any figure higher than
the current market price; if they attempt to charge a
higher price, potential buyers will simply make their
purchases from other wheat farmers. Further, the farm-
ers certainly would not knowingly charge a lower price,
because they could sell all they want at the market price.
price takers
a perfectly competitive firm that
takes the price it is given by the
intersection of the market demand
and market supply curves
SECTION 13.2
E XHIBIT 1
Market and Individual Firm Demand Curves in a Perfectly Competitive Market
a. Individual Firm Demand Curve
b. Market Supply and Demand Curve
Market price
and output
determined
here
S
Firm's Demand
Curve
$5
d
$5
Firm is a price taker
—must take market price
D
0
0
100
200
150
Quantity of Wheat
(millions of bushels)
Quantity of Wheat
(bushels)
At the market price for wheat, $5, the individual farmer can sell all the wheat he wishes. Because each producer
provides only a small fraction of industry output, any additional output will have an insignificant impact on market
price. The firm’s demand curve is perfectly elastic at the market price.
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