Chapter 9 - PRICE-SEARCHER MARKETS WITH LOW ENTRY BARRIERS
Price takers just take the market price - there is no pricing decision, no
advertising, no marketing, etc. They can adjust their output (expand/contract) and
they can try to reduce costs of production, but they have no pricing decision.
We now look at Competitive Price-Searcher Markets, where:
1) firms face a downward sloping demand curve for their product or service, and
2) there is easy entry/exit. With low entry barriers, the smell of profits will
Price-searching firms face a more complex set of decisions - see opening quote.
Firms never really directly observe demand curves, so they have to engage in a
process of trial-and-error to search for the price that maximizes profits. Since
markets are continually changing, the price searching process is continual and
ongoing, e.g. airlines, long distance, computers, online services, etc.
Firms are now selling differentiated products with brand names and have pricing
decisions - how to market, advertising, bundling (computer + printer), specials,
discounts, promotions, rebates, coupons, quantity discounts, senior citizen
discounts, price discrimination, etc.
However, there are usually many close substitutes so these markets are competitive
- fast food, cell phones, airlines, computers, athletic shoes, etc. A price-
searching firm can raise its prices and NOT lose all its customers, unlike a price-
taker. However, because there are lots of close substitutes, the demand curve
facing an individual firm will be highly ELASTIC.
The firm faces competition from two sources:
1) all existing firms and
2) potential rivals or competitors who will enter the industry if profits are high,
e.g. coffee shops, online services. "The smell of profits."
Firms can set price, but then market forces determine how much is actually sold at
a given price. Firms attempt to find the Price-Quantity combinations that MAX
Firms also can control more than just Price, they can control other non-Price
factors that affect consumer value: Quality, location, service, advertising,
convenience, bonuses (frequent flier miles), etc. Main Point: price-searching
firms face a complex set of decisions, compared to price-taker.
PRICE AND OUTPUT
How does a price-searcher decide on the Price-Output combination that MAX PROFITS?
A firm faces a trade-off when changing its price. If price is lowered, more units
are sold, but at a lower price for ALL units. If price is raised, fewer units are
sold, but at a higher price for ALL units. See page 238. Firm lowers price from
P1 to P2 and output expands from q1 to q2. There are two effects:
1. (P2 - P1) x q1 = Loss of Total Revenue from selling the original units (q1) at a
new lower price (P2), since the new price (P2) applies to both new customers and
2. (q2 - q1) x P2 = Gain in Total Revenue from attracting more customers (q2 - q1)
times the new Price (P2).
Because of these conflicting forces on TR, the marginal revenue (MR) will always be less than Price, and the MR curve will always be below the Demand curve, see page
PROFIT MAX RULE: Expand output as long as MR > MC. See page 239. At all units up
to q, MR > MC, which increases profits. Beyond q, MC > MR, which will reduce
profits. Firm should produce q units to Max Profits (Min losses).
1. MR = MC determines profit maximizing (loss minimizing) level of output.
2. Based on Profit Max output level q, we can determine the price (P) from the
Demand curve (d).
3. Based on P, we can determine profits (losses) by comparing P vs. ATC.
On page 239, TR = 0PAq and TC = 0CBq. Since TR - TC = PROFITS, the yellow shaded
area represents the economic profits.
The Economic Profits of the firm will now attract competition into the market since
barriers to entry are low - competitors will expand output and new firms will enter
the industry. Eventually, other firms will take away some the original firm's
business and the demand curve will shift back until the firm will just cover its
costs of production and P = ATC as on page 240. Economic profits will be zero and
there will be no more pressure to enter the industry.
In the long run, the price-searching firm will look like page 240. P = ATC, firms
are covering all costs of production (including opp costs of capital, etc.),
economic profits are zero, firms are earning a risk-adjusted normal rate of return.
In the SR, price-searching firms can either make economic profits or economic
losses. Economic profits attract entry and drive prices down to ATC. Economic
losses cause competitors to leave the industry, surviving firms can eventually
raise prices to cover ATC, economic profits will return to zero.
LR = Zero Economic Profits = Risk-adjusted Normal Rate of Return = Rate-of- Return
Very competitive price-searching markets where:
1. Barriers to entry and exit are low. Easy for firms to enter/exit the industry.
2. Zero economic profits in LR (P = ATC)
3. Minimum cost/most efficient method of production will prevail since both high
prices and high/inefficient production costs will attract entry.
Potential, as well as current/existing competition will discipline firms in
contestable markets. Implication of this is that even an industry with one
dominant firm (software industry, Microsoft) can be contestable (competitive) if
the threat of competition is sufficient to discipline the dominant firm. The
dominant firm has incentive to keep prices so low that no other firm can
successfully challenge their position. Example: Alcoa Aluminum.
Policy implication: If an industry is seen as not sufficiently competitive, we
should look at what can be done to make the industry more contestable. What
barriers to entry exist that can be removed or reduced? In many cases the way to
make the industry more competitive is to DEREGULATE the industry, since regulations
form a barrier to entry.
Examples: Airline Industry
Occupational Licensing - MDs , JDs Barbers, etc.
THE LEFT-OUT VARIABLE: ENTREPRENEURSHIP
Our economic model provides a general framework for analyzing the decision making
elements common to all firms - sole proprietorships to GM and Microsoft. What we
can accurately model is the general behavior that describes Profit Maximizing
behavior by firms. We know that successful firms do something that accounts for
their business success over time - Microsoft and GM engage in decision making that
is consistent with our economic models even though Bill Gates may have never taken
an economics class. Many successful entrepreneurs make decisions intuitively, and
pure entrepreneurial behavior can not accurately be modeled with graphs and
equations. There is no way to precisely model complex decision making of an
entrepreneur involving uncertainty, risk, discovery, innovation, creativity, etc.
Entrepreneurs are at the center of economic activity in the real world, even though
they are not in economic models. Business is part art and part science, we can
model the scientific part much easier than the part of business that is an "art."