MANAGERIAL

ECONOMICS 11th Edition

By
Mark Hirschey
Competitive Markets
Chapter 10
 Chapter 10
OVERVIEW
 Competitive Environment
 Factors That Shape the Competitive
Environment
 Competitive Market Characteristics
 Profit Maximization in Competitive Markets
 Marginal Cost and Firm Supply
 Competitive Market Supply Curve
 Competitive Market Equilibrium
 Competitive Environment
 What is Market Structure?
 A market consists of all firms and individuals willing
and able (potential entrants) to buy or sell a particular
product at a given time and place.
 Market structure describes the competitive
environment in the market for any good or service.
Four important industry characteristics:
1. Number of buyers, sellers and potential entrants.
2. The degree to which products are similar or dissimilar.
3. The amount and cost of information about product
price and quality.
4. Barriers to entry and exit, etc.
 Vital Role of Potential Entrants
 Competition comes from actual and potential
competitors.
 Potential entrants often affect price/output
decisions.
 Factors that Shape the Competitive
Environment
 The competitive environment is shaped by
the number and relative size of buyers and
sellers, and the extent to which the product
is standardized. In turn, these factors are
influenced by distinctive production
methods, and entry and exit condition)
 Product Differentiation
 Real or perceived differences in the quality of
goods and services.
 R&D, innovation, and advertising are
important in many markets
 Competitive markets characterized by
vigorous rivalry among competitors offering
essentially the same product.
 Production Methods
 Economies of scale can preclude small-firm size.
 Entry and Exit Conditions
 Barriers to entry and exit can shelter incumbents
from potential entrants.
 Barrier to mobility: any factor or industry
characteristics that creates an advantage for
large leading firms over smaller nonleading rivals
 Buyer Power
 Powerful buyers can limit seller power.
Competitive Market Characteristics
 Perfect Competition: a market structure
that exists when
1. All firms produce homogenous product
2. Each firm is so small it cannot affect price.
3. Entry and exit are unrestricted
4. Each firm has complete knowledge about
production and prices
5. Individual buyers and sellers are price takers
 Examples of Competitive Markets
 Agricultural commodities.
 Prominent markets for intermediate goods
and services.
 Unskilled labor market.
 Profit Maximization in Competitive
Markets
 Profit Maximization Imperative.
 In competitive markets, firms are price takers.
Their individual production decisions have no
effect on market prices. Therefore, maximum
profits result when the market price is set
equal to marginal cost. In a competitive
market a firm “might” be able to control costs.
  Normal profit is return necessary to attract
and maintain capital investment.
 Efficient firms can earn normal profit.
 Inefficient firms suffer losses.
 Role of Marginal Analysis
 Set Mπ = MR – MC = 0 to maximize profits.
 MR=MC when profits are maximized.
Marginal Cost and Firm Supply
 Short-run Firm Supply
 Marginal cost curve is the short-run

supply curve so long as P > AVC .

 The point of minimum ATC is found by setting
MC=ATC and solving for Quantity.
 The minimum point on the AVC is found by
setting MC=AVC and solving for quantity.
 Competitive market price (P) is shown as a
horizontal line because P=MR.
 Only in competitive markets P=AR=MR=MC at
the profit maximizing activity level.
Short-run Firm Supply. Produce Pride, Inc., supplies sweet corn to canneries located
throughout the Missouri River Valley. Like many grain and commodity markets, the
market for sweet corn is perfectly competitive. With $500,000 in fixed costs, the
company's total and marginal costs per ton (Q) are:

TC = $500,000 + $400Q + $0.04Q2

MC = TC/Q = $400 + $0.08Q

A. Calculate the industry price necessary to induce short-run firm supply of 5,000,
10,000, and 15,000 tons of sweet corn. Assume that MC > AVC at every point along
the firm's marginal cost curve and that total costs include a normal profit.

B. Calculate short-run firm supply at industry prices of $400, $1,000, and $2,000 per
ton.
 Long-run Firm Supply
 Marginal cost curve is the long-run supply
curve so long as P > ATC.
 In long run, firm must cover all necessary
costs of production and earn a normal profit.
Long-run Firm Supply. The Los Angeles retail market for unleaded gasoline
is fiercely price competitive. Consider the situation faced by a typical gasoline
retailer when the local market price for unleaded gasoline is $2.50 per gallon
and total cost (TC) and marginal cost (MC) relations are:

TC = $156,250 + $2.25Q + $0.0000001Q2

MC = TC/Q = $2.25 + $0.0000002Q

and Q is gallons of gasoline. Total costs include a normal profit.

A. Using the firm's marginal cost curve, calculate the profit-maximizing

long-run supply from a typical retailer

B. Calculate the average total cost curve for a typical gasoline retailer, and
verify that average total costs are less than price at the optimal activity level.
 Competitive Market Supply Curve
 Market Supply Short Run (Fixed Number
of Competitors) : Supply is the sum of
competitor output.
 Market Supply Long Run : Entry and Exit
Cause Market Supply to be perfectly
elastic at the market price
 Market Supply With Entry and Exit
 Entry results in more firms, increased output, a
rightward shift in the supply curve, and drives
down prices and profits.
 Exit reduces the number of firms, decreases the
quantity of output, shifts the supply curve
leftward, and allows prices and profits to rise for
remaining competitors.
Short-run Market Supply. Carolina Textiles, Inc., is a small manufacturer of
cotton linen that it sells in a perfectly competitive market. Given $100,000 in
fixed costs per day, the daily total cost function for this product is described by:

TC = $100,000 + $2Q + $0.0625Q2

MC = TC/Q = $2 + $0.125Q

where Q is units of cotton linen produced per day. Assume that MC > AVC at
every point along the firm's marginal cost curve, and that total costs include a
normal profit.

A. Derive the firm's supply curve, expressing quantity as a function of price.

B. Derive the market supply curve if North Carolina Textiles is one of 1,000
competitors.

C. Calculate market supply per day at a market price of $47 per unit.
.
Long-run Competitive Firm Supply. Calvin's Barbershop is a popularly-priced hair
cutter on the south side of Chicago. Given the large number of competitors, the fact that
barbers routinely tailor services to meet customer needs, and the lack of entry barriers, it is
reasonable to assume that the market is perfectly competitive and that the average $10
price equals marginal revenue, P = MR = $10. Furthermore, assume that the barbershop's
monthly operating expenses are typical of the 50 barbershops in the local market and can
be expressed by the following total and marginal cost functions:

TC = $9031.25 + $1.5Q + $0.002Q2

MC = $1.5. + $0.004Q

where TC is total cost per month including capital costs, MC is marginal cost, and Q is the
number of hair cuts provided. Total costs include a normal profit.

A. Calculate Calvin's profit-maximizing output level.

B. Calculate the Calvin's economic profits at this activity level. Is this activity level
sustainable in the long run?
Competitive Market Equilibrium
 Balance of Supply and Demand
 Equilibrium is a balance of supply and
demand.
 Normal Profit Equilibrium
 With a horizontal market demand curve,
MR=P.
 P=MR=MC=ATC.
 There are no economic profits.
 All firms earn a normal rate of return.
Perfectly Competitive Equilibrium. Fuel costs have risen sharply during
recent years as consumption, refining and production costs have increased.
Demand and supply conditions in the perfectly competitive domestic crude oil
market are:

P = $105 - 1.5QD (Demand)

P = $37.50+ 0.75QS (Supply)

where P is price per barrel and Q is quantity in millions of barrels per day.

A. Graph industry demand and supply curves.

B. Determine both graphically and algebraically the equilibrium industry

price/output combination.
 Self Test Problem 1

A. The marginal cost curve constitutes the short-run supply curve for firms in perfectly
competitive markets so long as price is greater than average variable cost.
Market Supply is the Sum of Firm Supply Across all
Competitors

Firm One Firm Two Firm Three

Supply Supply Supply Market Supply
P = MC1= P = $3.125 +
P = MC2= $15 + P = MC3= $1 +
$5 + $0.0004Q1 $0.000125P and
$0.002Q2 and $0.0002Q3 and
Price and QI = -25,000 +
Q2 = -7,500 + Q3 = -5,000 +
Q1 = -12,500 + 8,000P (QI = Q1
500P 5,000P
2,500P + Q2 + Q3)
$0 -12,500 -7,500 -5,000 -25,000
5 0 -5,000 20,000 15,000
10 12,500 -2,500 45,000 55,000
15 25,000 0 70,000 95,000
20 37,500 2,500 95,000 135,000
25 50,000 5,000 120,000 175,000
30 62,500 7,500 145,000 215,000
35 75,000 10,000 170,000 255,000
40 87,500 12,500 195,000 295,000
45 100,000 15,000 220,000 335,000
50 112,500 17,500 245,000 375,000
55 125,000 20,000 270,000 415,000
60 137,500 22,500 295,000 455,000
65 150,000 25,000 320,000 495,000
70 162,500 27,500 345,000 535,000
75 175,000 30,000 370,000 575,000
80 187,500 32,500 395,000 615,000
B
A.
Self Test Problem 2
Quantity Supplied
by Firm (000)
= Partial Market Supply = Total Market
Price 1+2 +3 +4 +5  1,000 Supply (000)
$1 20 18 52 32 18 140 140,000
2 22 24 64 44 26 180 180,000
3 24 30 76 56 34 220 220,000
4 26 36 88 68 42 260 260,000
5 28 42 100 80 50 300 300,000
6 30 48 112 92 58 340 340,000
7 32 54 124 104 66 380 380,000
8 34 60 136 116 74 420 420,000
The data in the Table illustrate the process by which an industry supply curve is constructed.
First, suppose that each of five firms in an industry is willing to supply varying quantities at
different prices. Summing the individual supply quantities of these five firms at each price
determines their combined supply schedule, shown in the Partial Market Supply column.
For example, at a price of $2, the output supplied by the five firms are 22, 24, 64, 44, and 26
(thousand) units, respectively, resulting in a combined supply of 180(000) units at that price.
With a competitive market price of $8, supply quantities would become 34, 60, 136, 116,
and 74, for a total supply by the five firms of 420(000) units, and so on.
Now assume that there are 1,000 firms just like each one illustrated in the table. There
are actually 5,000 firms in the industry, each with an individual supply schedule identical to
one of the five firms illustrated in the table. In that event, the total quantity supplied at each
price is 1,000 times that shown under the Partial Market Supply schedule. Because the
numbers shown for each firm are in thousands of units, the total market supply column is in
thousands of units. Therefore, the number 140,000 at a price of $1 indicates 140 million
units, the number 180,000 at a price of $2 indicates 180 million units, and so on.
B. To find the market supply curve, simply sum each individual firm’s supply curve,
where quantity is expressed as a function of the market price:
QI = Q1 + Q2 + Q3 + Q4 + Q5
= 18 + 2P +12 +6P +40 + 12P +20 +12P +10 +8P
= 100 + 40P (Market Supply)

Plotting the market demand curve and the market supply curve allows one to determine the equilibrium
market price of $6 and the equilibrium market quantity of 340,000(000), or 340 million units.
To find the market equilibrium levels for price and quantity algebraically, simply set the market demand
and market supply curves equal to one another so that QD = QS. To find the market equilibrium price, equate
the market demand and market supply curves where quantity is expressed as a function of price:
Demand = Supply
400,000 - 10,000P = 100,000 + 40,000P
50,000P = 300,000
P = $6
To find the market equilibrium quantity, set equal the market demand and market supply curves where
price is expressed as a function of quantity, and QD = QS:
Demand = Supply
$40 - $0.0001Q = -$2.5 + $0.000025Q
0.000125Q = 42.5
Q = 340,000(000)
Therefore, the equilibrium price-output combination is a market price of $6 with an equilibrium
output of 340,000(000), or 340 million units.