Economics for Managers Global Edition

3rd Edition farnham Solutions Manual

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 Chapter 7: Market Structure: Perfect Competition 69

CHAPTER 7: MARKET STRUCTURE: PERFECT

COMPETITION

OVERVIEW

This chapter begins the discussion on Market Structure or Industrial Organization in Economics.
The chapter introduces the Perfectly Competitive model. Perfect competition is important as a
stand-alone model and also as a comparison tool for the other market structures. As a stand-alone
model, it allows students to understand what happens in a market when no individual firm has any
market power and therefore takes the market price as given. It also defines the conditions for price-
taking behavior. As a comparison tool, it allows students to see the impact lack of competition and
presence of significant market power can have on the market, the consumer, and the economy as a
whole.

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.

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

D. The chapter begins with the US potato industry as an illustration of a perfectly

competitive market and the strategies used by potato farmers to shield themselves
form the volatility of the competitive market.

II. Case for Analysis: Competition and Cooperative Behavior in the Potato Industry

A. Agriculture as a sector and potato growing as an industry are potential illustrations

of perfect competition as they seem to meet the assumptions of the model. A large
number of farmers and lack of product differentiation reduce the market power of
each farmer.
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 Chapter 7: Market Structure: Perfect Competition 70

B. As a result of the competitive environment, the industry experiences significant

price volatility causing periodic hardships to potato growers.
1. In 1996, the price per 100 pounds decreased from $8 (1995) to
n$1.50–2.00 (1996).
2. High prices induce greater production and result in lower price next year.

C. Idaho farmers managed to differentiate Idaho grown potatoes from others. This
product differentiation is an important step at establishing market power because it
effectively splits the market.

D. In 2004, Idaho farmers formed a cooperative, United Potato (a very cute name),
which has successfully united farmers to curb production
1. Potato production was cut by $6.8 million in 2005.
2. Revenues shot up by 48.5% in 2005.
3. Legal issues (United Potato argued that Capper-Volstead Act exempts
farmers from federal antitrust laws and permit then to share price and
control supply).

E. Potato market is also influenced by changes on the demand side.

1. Dietary changes (a Harvard study showed that potatoes were one of the
leading factors responsible for weight gain)
2. Slower expansion of the fast food industry in the US and Japan and the
demand for French fries.
3. Development by the US Department of Agriculture of a competing
product: a French fry made from a mix or rice flour.

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. Try to make sure that the students
understand the role of each of the assumptions.

B. Perfectly competitive firms are price-takers.

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 Chapter 7: Market Structure: Perfect Competition 71

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

firm cannot influence the price of its product but can sell any amount of
output at the market established price.

C. Table 7.1 contrasts the four market structures and presents an easy teaching tool for
comparing the characteristics of the four market environments.

D. Model of the Industry or Market and the Firm

1. The market demand and supply determine market price of the good (and
the market quantity of output).

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

horizontal at the market determined price. This constitutes price-taking.

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

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 Chapter 7: Market Structure: Perfect Competition 72

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)

MC = Marginal Cost = (∆TC/∆Q)

4. Given that a perfectly competitive firm faces a horizontal demand, the

price and marginal revenue are the same. This is only true for firms with no
market power (facing a horizontal demand). A price-taking firm does not
need to lower the price to sell one more unit of output, making the revenue
change equal the price.

Teaching Tip: Depending on the level of preparation of the students, different

approaches can be undertaken to derive or illustrate the profit maximizing role of
equation 7.2. For students with calculus background, differentiating the profit
function with respect to output maybe an appropriate technique. For students with
no calculus background a proof by contradiction can be done. For instance, with an
output level where MC < MR, it is profitable to expand production as the next unit
produced increases profits (the contribution to the revenue side exceeds the
contribution to the cost side). However, as the output is increased, MC increases
(due to the law of diminishing marginal product). In the case of perfect competition,
this is sufficient since MR is constant. This, rising the output level increases the MC
and causes the relationship between MC and MR to move towards equality. The
same can be done on the other side of the equilibrium with MC > MR.

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.

Teaching Tip: it is important to emphasize that profit maximization does not mean
positive profits. In the case of losses, profit maximization is synonymous with loss
minimization.

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.
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 Chapter 7: Market Structure: Perfect Competition 73

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, i.e. 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 revenues of the firm do not cover the cost of variable inputs (in our
model that is labor), then it makes no sense to employ those inputs. In this case, the
firm shuts down and faces only the fixed costs. If revenue from production exceeds
the variable costs of production (while the firm is still earning negative profits) then
the firm should continue to operate because losing all of the fixed costs is worse
than losing only a percentage of them. This may also serve as a good time to recall
the concept of opportunity cost in economics.

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.

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

upward sloping.

E. 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.

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 Chapter 7: Market Structure: Perfect Competition 74

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.

F. 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.

Teaching Tip: It is a common mistake for the students to confuse the terminology,
“shut down” (a short-run decision) and “exit” (a long-run decision). 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 there
is no more incentive for new firms to enter. The market reaches its long-
run equilibrium.

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

G. Adjustment in the Potato Industry

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

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 Chapter 7: Market Structure: Perfect Competition 75

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.

H. 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.

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

scale and diseconomies of scale for the firm.

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 Chapter 7: Market Structure: Perfect Competition 76

(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: Incurring 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.

Teaching Tip: At this point it may make sense to show the students why perfect competition
represents the perfect world for the economy (not firms in the industry). Economic efficiency is
reached. The model guarantees minimization of costs of production in the long-run. The model
guarantees that the market generates the most surplus by setting the marginal cost equal to the
price. The last point is optional in a managerial economics course, but could be used to show
why perfect competition is desirable from the economy’s perspective.

IV. Other Illustrations of Competitive Markets

These cases illustrate that one of the most common approaches undertaken by managers
in trying to reduce the competitive pressure on their firms is to differentiate their
product. Product heterogeneity reduces the level of competitive pressure and if
successful shifts the firm into a different theoretical framework of analysis –
monopolistic competition.

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.

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 Chapter 7: Market Structure: Perfect Competition 77

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

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 food
system.

(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.

(a) In 2012, two studies demonstrated that red meat increases the
probability of developing health conditions including cancer, and can
even increase the probability of a premature death.

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 Chapter 7: Market Structure: Perfect Competition 78

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.

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.

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 Chapter 7: Market Structure: Perfect Competition 79

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.

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