Competitive Price-Searcher Markets and Entrepreneurship
Price-Searcher Markets with Low Entry Barriers
Firms in these markets face a downward-sloping demand curve.
Firms can set prices but face strong competition from existing firms and potential rivals.
Another term for these markets is monopolistic competition.
Product Differentiation
Price searchers offer differentiated products varying in design, dependability, location, ease of purchase, etc.
Rival firms produce similar products (good substitutes), leading to highly elastic demand curves for each firm.
Price and Output
A profit-maximizing price searcher expands output as long as marginal revenue (MR) exceeds marginal cost (MC).
Price is lowered, and output is expanded until MR = MC.
The price charged by a price searcher will be greater than its marginal cost.
Consider a market with initial price P1 and output q1. Total revenue (TR) is P1 \times q1.
With a downward-sloping demand curve, price reductions that increase sales have conflicting influences on TR.
As price falls from P1 to P2, output increases from q1 to q2.
TR rises due to increased units sold: (q2 – q1) \times p_2.
TR declines because q1 units, once sold at P1, are now sold at P2: (P1 – P2) \times q1.
Because of these conflicting effects marginal revenue (MR) will be Marginal Revenue of a Price Searcher
Price and Output: Short-Run Profit
A price searcher maximizes profits by producing where MR = MC, at output level q, charging price P along the demand curve.
At q, the average total cost is C.
If price > average total cost (P > C), the firm makes economic profits equal to (P - C) \times q.
Positive economic profits attract rival firms to the market.
Profits and Losses in the Long Run
Economic profits attract rival firms, expanding supply and lowering prices.
Each firm's demand curve shifts inward until economic profits are eliminated.
Economic losses cause price searchers to exit the market.
Demand for remaining firms' output rises until losses are eliminated, removing the incentive to exit.
Competitive price searchers can make profits or losses in the short run but only zero economic profit in the long run.
Entry and exit are free, competition eventually drives prices to the level of ATC.
When profits (losses) are present, the demand curve shifts inward (outward) until zero profit equilibrium is restored.
The price searcher establishes output where MC = MR.
At q, average total cost equals the firm’s price P, resulting in zero economic profit.
No incentive exists for firms to enter or exit.
Contestable Markets and the Competitive Process
A contestable market has low entry and exit costs with no legal barriers to entry.
Example: Airline industry
Actual and potential competition leads to:
Zero economic profits
Efficient production
Comparing Price Searchers and Takers
Illustrate the long-run equilibrium for both price-taker and price-searcher markets with low entry barriers.
With each, P = ATC, resulting in no economic profits.
Price searchers face a downward-sloping demand curve, their profit-maximizing price exceeds MC.
In contrast with price-taker market, the price-searcher’s q is too small to minimize ATC in long-run equilibrium.
Even though the two markets have the same cost structure, the price in the price-searcher market is higher than that in the price-taker market ( P2 > P1 ).
Some consider this price discrepancy a sign of inefficiency; others perceive it as the price paid for product variety & dynamic improvement in products over time.
Price Discrimination
Price discrimination: When a seller charges different consumers different prices for the same good or service.
Price discrimination can only occur when a price searcher is able to:
identify groups of customers with different price elasticities of demand, and,
prevent customers from re-trading the product.
Sellers may gain from price discrimination by charging
higher prices to groups of customers with more inelastic demand, and,
lower prices to groups of customers with more elastic demand.
Price discrimination generally leads to more output and additional gains from trade.
Consider the market for airline travel where the Marginal Cost per traveler is $100.
If airlines charges all customers the same price, profits will be maximized where MC = MR.
Here the airline charges everyone $400 and sells 100 seats
This generates Net Operating Revenue of $30,000 or (total revenues) $40,000 minus (operating costs) $10,000.
By charging higher prices to consumers with less elastic demand and lower prices to those with more elastic demand it will increase net operating revenue.
If the airline charges $600 to business travelers (who have a highly inelastic demand) and $300 to other travelers (who have a more elastic demand), it can sell more seats (120 versus 100) and increase its Net Operating Revenue to $42,000.
Entrepreneurship and Economic Progress
Entrepreneurship: Entrepreneurial judgment and the development of improved products and production processes are a central element of economic progress.
Entrepreneurial judgment is necessary when there is no decision rule that can be applied using only information that is freely available.
For this reason, we are unable to incorporate fully the function of the entrepreneur into economic models.
There simply is no way to model these complex decisions that involve uncertainty, discovery, and business judgment.
An entrepreneur is someone who finds new combinations of resources and creates new products and production methods that did not previously exist.
Entrepreneurs who discover and introduce lower-cost production methods and new products that are highly valued relative to cost promote economic progress.
Entrepreneurs also have a strong incentive to discover the type of business structure, size of firm, and scope of operation that can best keep the per-unit cost of products or services low.
A growing, vibrant economy is characterized by the constant introduction of new products and services.
Nobody knows what the next innovative breakthrough will be or who will discover and develop it.
The only real test of a new product or service is to try it out within the framework of the competitive market process.
The rate of discovery will depend on the structure of rewards. In economies where it is attractive to discover new ways of doing things, the discovery rate of wealth creating opportunities will be higher and human progress more rapid.
Dynamic Competition, Innovation, and Business Failures
Business failures are usually reported as bad news about the economy.
Though business failures are painful for those directly involved, they release resources so they can be employed more productively elsewhere.
The assets and workers of failed firms become available for use by others supplying goods that consumers value more relative to costs.
Without this release of resources, economic expansion would be slowed.
The introduction of new and improved products often lead to obsolescence of others. Joseph Schumpeter referred to this process as ‘creative destruction.’
In a competitive economy numerous businesses regularly come and go. Each year newly created businesses account for about 10% of the total but 60% of them will fail within six years.