Competitive Markets

Market Structure and Firm Behaviour

Market structure describes the characteristics of a market that influence the behavior and performance of firms. Understanding these features helps explain how firms interact and compete.

• Market structure: All features of a market that affect firm behavior and performance, such as the number and size of sellers, knowledge of competitors' actions, freedom of entry and exit, and product differentiation.

• Market power: The ability of a firm to influence the price of its product.

Competitive Markets are those in which firms have little or no market power. The less market power firms have, the more competitive the market is. The extreme case is a perfectly competitive market, where each firm has zero market power.

Competitive Behaviour

Competitive behaviour refers to the extent to which firms actively compete for business. It is distinct from the competitiveness of the market itself.

• Example 1: MasterCard and Visa engage in competitive behaviour, but their market is not highly competitive due to limited firms and market power.

• Example 2: Two wheat farmers do not actively compete, but their market is very competitive because there are many sellers and no single farmer can influence the price.

The Theory of Perfect Competition

Assumptions of Perfect Competition

Perfect competition is an idealized market structure with several key assumptions:

• All firms sell a homogeneous product (no differentiation).

• Customers have full knowledge of the product and prices charged by each firm.

• The output level at which a firm's long-run average cost is minimized is small relative to the industry's total output.

• There is freedom of entry and exit in the industry.

Demand Curves in Competitive Markets

The demand curve faced by the industry is downward sloping, while the demand curve faced by an individual firm in perfect competition is perfectly elastic (horizontal).

• Firms are price takers: they accept the market price as given.

• Any realistic change in a single firm's output does not affect the market price.

Table: Comparison of Demand Curves

Why Small Firms Are Price Takers

• Market demand curves are negatively sloped, so increases in industry output lower the market price.

• However, a single firm's output change is too small to affect the market price, so each firm faces a horizontal demand curve.

Total, Average, and Marginal Revenue

• Total Revenue (TR): The total amount received from sales.

• Formula:

• Average Revenue (AR): Revenue per unit sold.

• Formula:

• Marginal Revenue (MR): The change in total revenue from selling one more unit.

• Formula:

• For a price-taking firm:

Short-Run Decisions

Profit Maximization

A firm's objective is to maximize profit ():

• Formula:

• If , the firm makes economic losses ().

Should the Firm Produce at All?

• If the firm produces nothing: (total fixed cost).

• If the firm produces something: (total variable cost).

• It is more profitable to produce if or (average variable cost).

• If or , the firm should shut down in the short run.

• Shut-down price:

How Much Should the Firm Produce?

• Produce the quantity where marginal revenue equals marginal cost:

• For a competitive firm:

Profit Maximization for a Competitive Firm

• Profit is maximized where the vertical distance between and is greatest (where their slopes are equal).

• For each unit sold, profit per unit is (average total cost).

• Formula: , where at the profit-maximizing output .

Short-Run Supply Curves

• A competitive firm's supply curve is its curve above its curve.

Industry Supply Curve

• The industry supply curve is the horizontal sum of all firms' curves (above ).

Short-Run Equilibrium in a Competitive Market

• Short-run equilibrium occurs when quantity demanded equals quantity supplied and each firm maximizes profit at the market price.

• Firms may be making losses, breaking even, or making profits.

Table: Short-Run Profit Outcomes

Long-Run Decisions

Entry and Exit

• Economic profits attract new firms (entry).

• Economic losses cause firms to leave (exit).

• If firms break even, there is no incentive for entry or exit.

Application: The Parable of the Seaside Inn

• Some hotels operate in the off-season at rates that do not cover full costs but do cover variable costs and part of fixed costs.

• They continue to operate as long as they cover variable costs.

Effects of Entry and Exit

• Entry: Increases supply, shifts the supply curve right, and lowers price until profits are zero.

• Exit: Decreases supply, shifts the supply curve left, and raises price until losses are eliminated.

Long-Run Equilibrium

• Occurs when firms earn zero economic profit (break-even).

• The market price equals the minimum point of the long-run average cost curve ().

• Firms cannot increase profit by changing plant size; all are at the minimum .

Short-Run vs. Long-Run Profit Maximization

• In the short run, firms may not be at the minimum .

• In the long run, competitive equilibrium requires all firms to operate at the minimum .

Changes in Technology

• Technological improvements lower costs for new plants, allowing them to earn economic profits.

• Entry of new plants increases industry output and lowers price to the new (short-run average total cost).

• Older plants may continue temporarily but will eventually exit if they cannot compete.

Declining Industries

• If demand continually decreases, the industry contracts and obsolete equipment is not replaced.

• Antiquated equipment is usually a result, not a cause, of industry decline.

Historical Example: Whales and Crude Oil

• High demand for whale oil in the 19th century led to rising costs as whale populations declined; kerosene replaced whale oil.

• Similarly, crude oil faces rising costs and the development of substitutes, signaling potential industry decline.