ECON201 - Chapter 9

Chapter 9: Competitive Markets

9.1 Market Structure and Firm Behaviour

  • Market Structure: Refers to the characteristics of a market affecting the behavior and performance of firms.

    • Features include:

      • Number and size of sellers.

      • Knowledge about other firms' actions.

      • Freedom of entry and exit.

      • Product differentiation.

  • Market Power: The ability of firms to influence the price of their product.

Competitive Markets

  • Defined as markets where firms have little or no market power.

  • Perfectly Competitive Market: An extreme case where each firm has zero market power.

Competitive Behaviour

  • Refers to how individual firms compete for business.

    • Example 1: MasterCard and Visa compete, but the market isn't fully competitive.

    • Example 2: Two wheat farmers are in a competitive market but do not engage in competitive behavior.

9.2 The Theory of Perfect Competition

  • Key Assumptions of Perfect Competition:

    1. All firms sell a homogeneous product.

    2. Customers are fully informed about products and prices.

    3. Individual firm output is small relative to total industry output.

    4. Freedom of entry and exit characterizes the industry.

Demand Curve for a Competitive Firm

  • Firm vs Industry Demand Curves: The firm faces a perfectly elastic demand, suggesting it cannot sell an infinite amount at the same price.

  • Any individual firm's production changes have negligible effects on the overall market price.

9.3 Short-Run Decisions

  • Profit Maximization: Firms aim to maximize profits defined as:

    • Profits = Total Revenue (TR) - Total Costs (TC).

  • If TR does not cover TC, firms incur economic losses.

Should the Firm Produce at All?

  • If producing incurs a loss, the firm should consider:

    • Producing nothing will result in fixed costs as losses.

    • Producing when revenue exceeds variable cost is advisable.

    • The 'shut-down price' occurs when the price equals the minimum average variable cost.

How Much Should the Firm Produce?

  • A firm should produce where marginal revenue (MR) equals marginal cost (MC) to maximize profits.

Short-Run Supply Curves

  • A competitive firm’s supply curve is represented by the marginal cost (MC) curve above the average variable cost (AVC).

9.4 Long-Run Decisions

  • Entry and Exit:

    • Positive economic profits attract new firms.

    • Zero profits deter entry and exit.

    • Economic losses prompt existing firms to exit.

Long-Run Equilibrium

  • Occurs when firms earn zero profits.

  • Break-even price allows firms to cover total costs, including opportunity costs.

  • Conditions for Long-Run Equilibrium:

    1. Firms maximize profits given existing capital.

    2. Firms neither suffer losses nor earn profits.

    3. Firms must not be able to change production size to increase profit.

    4. Firms operate at the minimum point of the long-run average cost (LRAC) curve.

Changes in Technology

  • New technology can lower the costs for newly built plants, granting them economic profits and attracting more firms.

  • Older plants may face losses and exit the market.

Declining Industries

  • Ongoing decreases in demand significantly challenge competitive industries.

    • Old equipment is often a symptom of industry decline rather than the cause.

Lessons from History: Whaling Ships and Oil Wells

  • Historical demand shifts led to the decline of industries.

    • Whaling faced cost increases due to dwindling populations and substitutes.

    • Modern oil production faces similar challenges with new energy sources and environmental concerns driving decline.