Economics For Managers 2nd Edition

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 Chapter 7: Market Structure: Perfect Competition 1

CHAPTER 7: MARKET STRUCTURE: PERFECT

COMPETITION

OVERVIEW

This chapter introduces students to perfect competition, a market structure where individual firms
have no market control over the product price. In the short run, firms take the market price and
maximize their profits. Profits earned can be positive, negative or zero in the short-run. In the
long-run, profits signal the entry of new firms and the exit of existing firms through the lack of
barriers. Any profits or losses will be competed away until all firms earn equilibrium zero profits.
Managers of competitive firms often attempt to gain market power by merging with other firms,
differentiating their products or forming associations to increase the industry demand, as illustrated
by the examples in the chapter.

OUTLINE OF TEXT MATERIAL

I. Introduction

A. There are four major forms of markets structure: perfect competition, monopolistic
competition, oligopoly and monopoly.

B. Perfectly competitive firms cannot influence the price of the product while
monopolies have the ability to do so due to market power.

C. Pricing strategies of managers depend on the market structure.

D. The Wall Street Journal article illustrates the deviation from perfect competition in
the potato industry as potato farmers collude with one another.

II. Case for Analysis: The Spud’s Not for You

A. The article discusses the emergence of the United Potato Farmers of America, a
farming cooperative, which helped manage the supply of potatoes so that prices
would be kept high to increase profits.

1. Like OPEC in the petroleum industry, the organization acts as a cartel.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
 Chapter 7: Market Structure: Perfect Competition 2

B. Traditionally, the high prices caused overproduction of potatoes that drove down
prices below costs of production resulting in an unprofitable industry.

C. There is great market volatility in the fresh vegetable market due to weather and
other factors.

1. In 1995, potatoes cost $8 per 100 pounds.

2. An overproduction of potatoes resulted in a lower price, between $1.50 and
$2 per 100 pounds.

D. Idaho farmers face competition from around the world.

1. The demand for potatoes is heavily influenced by the demand for French
fries.
2. U.S. exports of french fries doubled between 1989 and 1996 as the fast-
food industry grew.

E. United Potato has successfully united farmers to curb production to take advantage
of higher prices.

1. Potato production was cut by $6.8 million.

2. Revenues shot up by 48%.

F. The french fries industry’s demand may be affected by the U.S. Department of
Agriculture’s substitute product made from a rice flour mixture and changing
consumer preference in the future.

III. The Model of Perfect Competition

A. The assumptions of perfect competition are:

1. a large number of firms in the market;

2. an undifferentiated product;
3. ease of entry into the market or no barriers to entry; and
4. complete information available to all market participants.

Teaching Tip: Make sure the students understand that the model of perfect
competition is hypothetical. The potato industry and other agricultural markets
come close to perfectly competitive industries.

B. Perfectly competitive firms are price-takers.

1. Price-Taker: A characteristic of a perfectly competitive firm in which a

firm cannot influence the price of its product and can therefore sell any
amount of output at that price.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
 Chapter 7: Market Structure: Perfect Competition 3

C. Model of the Industry or Market and the Firm

1. The market demand and supply determine price of the good and the
quantity producers are willing to supply.

[[Insert Figure 7.1a here]]

2. The demand curve facing an individual firm is perfectly elastic or

horizontal, as it cannot influence the market price.

[[Insert Figure 7.1b here]]

3. The output produced by a competitive firm depends on the goal of the firm,
profit maximization.

(a) Profit Maximization: The assumed goal of firms, which is to develop

strategies to earn the largest amount of profits possible. This can be
accomplished by focusing on either revenues or costs or both factors.

(b) Equation 7.1: = TR-TC

where = Profit
TR= Total Revenue
TC=Total Cost

(c) Profit Maximization Rule: To maximize profits, a firm should

produce the level of output where marginal revenue equals marginal
cost.

(d) Equation 7.2: Produce the level of output where MR=MC

where MR= Marginal Revenue= (∆TR/∆Q)

where MC= Marginal Cost= = (∆TC/∆Q)

4. The marginal revenue equals the price and the demand curve is horizontal
only for a perfectly competitive firm. The reason is that it is a price-taker
and does not need to lower the price to sell more units of the output.

Teaching Tip: Students find it more intuitive to learn the profit maximization rule
not just with numbers but with a graph as well. In order to do so, it may be a good
idea to review how to calculate the marginal revenue and marginal cost and what
they represent to the firm.

5. If MR=MC, then the firm produces the optimal output level, Q*. At this
level of output, profits can be positive, negative or zero.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
 Chapter 7: Market Structure: Perfect Competition 4

6. An alternative method of calculating profit is the per-unit profit, (P-ATC),

multiplied by the quantity, Q.

Teaching Tip: It may also be a good idea to teach the profit area on the graph,
determined by (P-ATC)*Q or TR-TC so that students can see if a firm is making
positive, negative or zero profits.

7. Even if the firm is producing the output where MR=MC, it should stop
producing and shut down if the price is below AVC, or it cannot cover its
variable cost.

(a) Shut-Down Point: The price, which just equals the firm’s average
variable cost, below which it is more profitable for the perfectly
competitive firm to shut down than to continue to produce it.

Teaching Tip: This is a good place to review fixed and variable inputs to the firm.
Make sure that the students understand that the firm incurs the fixed costs of
production such as a rental fee for the plant facility regardless of the output
produced. If the firm cannot pay out the variable costs such as wages from its
revenue, then it is not profitable and decides to shut down.

8. The supply curve for the perfectly competitive firm is the portion of the
marginal cost curve that lies above the minimum average variable cost.

[[Insert Figure 7.2 here]]

9. The supply curve for the perfectly competitive industry or market is

upward sloping.

D. The Short Run in Perfect Competition

1. The firm cannot change the scale of operation in the short run since at least
one input is fixed.

2. Firms cannot enter or exit the industry in the short run.

3. Where P=MR=MC, the firm can be earning positive, negative or zero

profits. If the price is below the average variable cost, the firm shuts down.

E. Long-Run Adjustment in Perfect Competition: Entry and Exit

1. Entry and exit by new and existing firms and changes in the scale of
operation by all firms can occur in the long run.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

 Chapter 7: Market Structure: Perfect Competition 5

Teaching Tip: It is a common mistake for the students to confuse the terminology,
“shut down” and “exit.” Make sure you make the distinction between the decisions
of a competitive firm in the short run versus the long run.

2. Equilibrium Point: The point where price equals average total cost since
the firm earns zero economic profit.

3. An increase in the market demand raises the profits earned by all firms
through an increase in the price.

4. As there are no barriers, the positive profits signal new firms to enter the
market. Entry of new firms increases the market supply to the right.

5. Entry continues until all firms are once again earning zero profits and the
market is in long-run equilibrium.

[[Insert Figure 7.3a and 7.3b here]]

Teaching Tip: This is a good place to review the determinants of market demand
and supply.

F. Adjustment in the Potato Industry

1. The long-run adjustment process applies to the potato industry.

[[Insert Figure 7.4a and 7.4b here]]

2. The high price of $8 per 100-pound sack and profits earned by individual
farmers are shown in point A.

3. In response to the prices and profits, farmers planted more potatoes in

1996. The favorable weather and insect conditions helped increase the
supply and driving down the price to $2 per 100-pound sack.

4. The new price was below the average total cost for many farmers, leaving
them with significant debt.

G. Long-Run Adjustment in Perfect Competition: The Optimal Scale of Production

1. Entry and exit in a perfectly competitive industry result in the zero-profit

equilibrium (P=ATC).

2. Positive profits signal new firms to enter while negative profits signal firms
to exit the industry.

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 Chapter 7: Market Structure: Perfect Competition 6

3. The long-run average cost curve (LRAC) incorporates both economies of

scale and diseconomies of scale for the firm.

[[Insert Figure 7.5 here]]

(a) Economies of Scale: Achieving lower unit costs of production by

adopting a larger scale of production, represented by the downward
sloping portion of a LRAC.
(b) Diseconomies of Scale: Achieving higher unit costs of production by
adopting a larger scale of production, represented by the upward
sloping portion of a LRAC.

4. The two types of adjustments that are made to reach equilibrium

(P=LRAC) in the long run are:

(a) the choice of the scale of operation, and

(b) entry by firms that lowers product price and competes away any
positive economic profits.

IV. Other Illustrations of Competitive Markets

A. Farming is one of the best examples of a perfectly competitive industry.

B. A perfectly competitive industry is unconcentrated and each firm does not have any
market power.

1. Industry Concentration: A measure of how firms produce the total output

of an industry. The more concentrated the industry, the fewer the firms
operating in that industry.

C. Competition and The Agricultural Industry

1. There are still 2 million farms in the United States today.

2. Large scale farms dominate the market due to economies of scale.

3. The demand for most farm crops is highly inelastic. This means that a
decrease in price decreases the total revenues for producers, resulting in the
“farm problem” that industrialized countries face.

4. Governments have implemented farm price support programs to control

production. However, these have caused imbalances in demand and
supply.

D. Competition and the Broiler Chicken Industry

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
 Chapter 7: Market Structure: Perfect Competition 7

1. The broiler chicken industry was traditionally unconcentrated and

produced a relatively undifferentiated product. This has been changing.

2. Most of the increase in industry concentration resulted from mergers.

3. Real and subjective product differentiation exit among the different broiler
processors. One such example is skin color.

4. Competition depends on the market channel used and the extent of value-
added processing involved.

5. Broiler processing has the lowest price-cost margin (PCM) in the industry.

(a) Price-Cost Margin (PCM): The relationship between price and costs
for an industry, calculated by subtracting total payroll and the cost of
the materials from the value of shipments and then dividing the
results by the value of shipments. The approach ignores taxes,
corporate overhead, advertising, marketing, research, and interest
expenses.

E. Competition and the Red-Meat Industry

1. Managers in the red-meat packing industry have also turned to changing an

undifferentiated product into a brand name.

2. Branding represents a major shift in an industry that traditionally labeled

its low-end products such as Spam.

3. This shift has resulted from a declining demand for red-meat consumption
in the United States.

F. Competition and the Milk Industry

1. The “Got milk?” and milk mustache campaigns were strategies to increase
industry demand for milk.

2. The change in lifestyles and consumer tastes has led to increased strategies
for product differentiation in a highly competitive industry.

3. To appeal to the large Asian market, a New Zealand producer has

experienced with new flavors.

4. New Developments include the industry’s “3-A-day” campaign for

increased daily consumption of milk.

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 Chapter 7: Market Structure: Perfect Competition 8

G. Competition and the Trucking Industry

1. There are more than 150,000 companies in the truckload segment of the
industry.

2. The changing forces of demand and supply alter the profitability of

trucking companies.

3. Higher costs, adverse weather and an overall slowing in the economy in the
last quarter of 2000 led to numerous companies that went out of business.

4. The rising costs of labor, fuel and equipment plus the subprime mortgage
crisis in recent years have decreased demand.

V. Appendix 7A: Industry Supply

A. Elasticity of Supply

1. The shape of the industry supply curve illustrates the elasticity of supply
within that industry.

(a) A supply elasticity greater than 1 indicates an elastic supply while a

supply elasticity less than 1 indicates an inelastic supply.

(b) A perfectly inelastic supply curve is vertical supply curve while a

perfectly elastic supply curve is a horizontal supply curve.

B. Agricultural Supply Elasticity

1. The supply curves of various agricultural products are illustrated by an S-

shaped curve.

[[Insert Figure 7.A.1 here]]

2. Supply elasticity is lower for major crops grown in areas where there are
few alternatives for the use of land.

3. The aggregate supply relationship for all farm output in most countries is
very price inelastic in the short run.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall