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Chapter 9

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Queen's University
ECON 110
Ian James Cromb

Chapter 9: Competitive Markets Market Structure and Firm Behaviour  Market Structure refers to all features that may affect the behaviour & performance of the firms in a market  number of firms in the market or the type of products that they sell Competitive Market Structure  Economists say that firms have market power when they can influence the price of their product of the terms under which their product is sold o Competitiveness of market = degree to which individual firms lack market power o A market is said to have a competitive structure when firms have little/no market power – more market power firms have, the less competitive the market structure  Perfectly competitive market structure – when each firm has zero market power o So many firms that each must accept the price set by supply and demand o They perceive themselves as being able to sell as much as they choose at that market price and as having no power to influence the price o Since none has any power over the market, there is no need for individual firms to compete actively with one another Competitive Behaviour  Refers to the degree to which individual firms actively vie with one another for business o In a market that does not have a perfectly competitive market, companies can raise prices and still attract more customers since they have market power o In a perfectly competitive market, firms don’t have market power so the only way they can increase profit is by adjusting its costs – therefore these firms do not need to actively compete with each other The Significance of Market Structure  When a firm decides how much output to produce in order to maximize its profits, it needs to know the demand for its product and also the costs of production  Costs were looked at in chapters 7 and 8 – turn toward demand for the firm’s product o This is where market structure enters the picture – details of the market structure determine how we get from the industry demand curve to the demand curve facing any individual firm in that industry The Theory of Perfect Competition 1. Perfect Competition is a market structure in which all firms in an industry are price takers and in which there is freedom to entry into an exit from the industry The Assumptions of Perfect Competition 1. All firms in the industry sell an identical product – homogeneous product 2. Consumer know the nature of the product being sold and the prices charged by each firm 3. The level of each firm’s output at which its long run average cost reaches it minimum is small relative to the industry’s total output – each firm is small relative to the industry 4. The industry is characterized by freedom of entry and exit – any new firm s free to enter the industry and start producing if it so wishes and an existing firms are free to cease production and leave the industry – existing firms/regulations cannot block entry  The first 3 imply each firm is a price taker – accept whatever happens to the market price o The market price remains constant no matter how much they produce or sell The Demand Curve for a Perfectly Competitive Firm  Even though the demand curve for the entire industry is negatively sloped, each firm’s demand curve in a perfectly competitive market is horizontal – output doesn’t affect price o The elastic curve does not mean that they could sell an infinite amount – it just means that variations in production will leave the price unchanged Total, Average, and Marginal Revenue  Total Revenue (TR) is the total amount received by the firm on the sale of a product  Average Revenue (AR) is the amount of revenue per unit sold  TR/Quantity produced  Marginal Revenue (MR) is the change in a firm’s total revenue resulting from a change in its sales by one unit – whenever output changes by more than one unit. The change in revenue must be divided by the change in output to calculate the approximate the MR  If the market price is unaffected by variations in output, all three curve will coincide o For a firm in perfect competition, price equals marginal revenue Short-Run Decisions Should the Firm Produce at All?  If it produces nothing, it will have an operating loss equal to its fixed costs o If it chooses to produce  have to add the variable costs for each unit of output o If it cannot cover the variable costs with its sales, the firm is better off if it produces nothing at all  A firm should produce nothing if, for all levels of output, total variable cost for producing that output exceed the total revenue gained from selling that output How Much Should the Firm Produce?  If any unit of output generates from revenue then costs, producing that unit will have better profits – marginal revenue exceeds marginal costs  If it is worthwhile for a firm to produce at all, the firm should produce the output at which marginal revenue equals or exceeds marginal cost In a perfectly competitive industry, the market determines the price at which the firm sells its product. The firm then decides how much it wants to produce in order to maximize profits Short-Run Supply Curves The Supply Curve for One Firm  For prices below the average variable cost, the firm will supply zero units  For prices above the average variable cost, the firm will choose its level of output to equate price and marginal cost o A firm’s supply curve is given by the portion of its marginal cost curve that is above its average variable cost curve The Supply Curve of an Industry  In perfect competition, the industry supply curve is the horizontal sum of all the marginal cost curves – that are above the average variable cost – of all firms in the industry Short-Run Equilibrium in a Competitive Market  The collective actions of all of the firms (supply) and the collections actions of all of the households (demand) determine the equilibrium price  When a perfectly competitive industry is in short-run equilibrium, each firm is producing and selling a quantity for which its marginal cost equals the market price o No firm is motivated to change output in the short run – since Q = Q D S  A firm will have economic profits when the equilibrium price is higher than the firm’s average total costs of its output  Even if a firm produces at an economic loss, it may still be better than not producing at all – the firm will be able to cover SOME of its fixed costs Long-Run Decisions  Assume all firms have the same technology – and therefore the same cost curves o Thus, the short-run equilibrium in the industry will have all firms being equally profitable Exit and Entry  The key difference between a perfectly competitive industry in the short-run and long-run is the entry or exit of firms  We have seen that all firms in an industry may make profit, loss, or break even o But cost include the opportunity cost of capital, if firms are just breaking even they are doing just as well in that industry as opposed to another one o Hence, there will be no incentives for firms to leave or enter o If existing firms are earning profits, new firms will eventually enter the market o If firms are receiving losses, existing firms will eventually leave the market An Entry-Attracti
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