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8 Market Structure: Perfect Competition and Monopoly One of the most important decisions made by a manager is how to price the firm’s product. If the firm is a profit maximizer, the price charged must be consistent with the realities of the market and economic environment within which the firm operates. Remember, price is determined through the interaction of supply and demand. A firm’s ability to influence the selling price of its product stems from its ability to influence the market supply and, to a lesser extent, on its ability to influence consumer demand, as, say, through advertising. One important element in the firm’s ability to influence the economic environment within which it operates is the nature and degree of competition. A firm operating in an industry with many competitors may have little control over the selling price of its product because its ability to influence overall industry output is limited. In this case, the manager will attempt to maximize the firm’s profit by minimizing the cost of production by employing the most efficient mix of productive resources. On the other hand, if the firm has the ability to significantly influence overall industry output, or if the firm faces a downward-sloping demand curve for its product, the manager will attempt to maximize profit by employing an efficient input mix and by selecting an optimal selling price. Definition: Market structure refers to the environment within which buyers and sellers interact. CHARACTERISTICS OF MARKET STRUCTURE There are, perhaps, as many ways to classify a firm’s competitive environment, or market structure, as there are industries. Consequently, no 313 314 Market Structure: Perfect Competition and Monopoly single economic theory is capable of providing a simple system of rules for optimal output pricing. It is possible, however, to categorize markets in terms of certain basic characteristics that can be useful as benchmarks for a more detailed analysis of optimal pricing behavior. These characteristics of market structure include the number and size distribution of sellers, the number and size distribution of buyers, product differentiation, and the conditions of entry into and exit from the industry. NUMBER AND SIZE DISTRIBUTION OF SELLERS The ability of a firm to set its output price will largely depend on the number of firms in the same industry producing and selling that particular product. If there are a large number of equivalently sized firms, the ability of any single firm to independently set the selling price of its product will be severely limited. If the firm sets the price of its product higher than the rest of the industry, total sales volume probably will drop to zero. If, on the other hand, the manager of the firm sets the price too low, then while the firm will be able to sell all that it produces, it will not maximize profits. If, on the other hand, the firm is the only producer in the industry (monopoly) or one of a few large producers (oligopoly) satisfying the demand of the entire market, the manager’s flexibility in pricing could be quite considerable. NUMBER AND SIZE DISTRIBUTION OF BUYERS Markets may also be categorized by the number and size distribution of buyers. When there are many small buyers of a particular good or service, each buyer will likely pay the same price. On the other hand, a buyer of a significant proportion of an industry’s output will likely be in a position to extract price concessions from producers. Such situations refer to monopsonies (a single buyer) and oligopsonies (a few large buyers). PRODUCT DIFFERENTIATION Product differentiation is the degree that the output of one firm differs from that of other firms in the industry. When products are undifferentiated, consumers will decide which product to buy based primarily on price. In these markets, producers that price their product above the market price will be unable to sell their output. If there is no difference in price, consumers will not care which seller buy from. A given grade of wheat is an example of an undifferentiated good. At the other extreme, firms that produce goods having unique characteristics may be in a position to exert considerable control over the price of their product. In the automotive industry, for example, product differentiation is the rule. 315 Characteristics of Market Structure CONDITIONS OF ENTRY AND EXIT The ease with which firms are able to enter and exit a particular industry is also crucial in determining the nature of a market. When it is difficult for firms to enter into an industry, existing firms will have much greater influence in their output and pricing decisions than they would if they had to worry about increased competition from new comers, attracted to the industry by high profits. In other words, managers can make pricing decisions without worrying about losing market share to new entrants. Thus if a firm owns a patent for the production of a good, this effectively prohibits other firms from entering the market. Such patent protection is a common feature of the pharmaceutical industry. Exit conditions from the industry also affect managerial decisions. Suppose that a firm had been earning below-normal economic profit on the production and sale of a particular product. If the resources used in the production of that product are easily transferred to the production of some other good or service, some of those resources will be shifted to another industry. If, however, resources are highly specialized, they may have little value in another industry. In this and the next two chapters we will examine four basic market structures: perfect competition, monopoly, oligopoly, and monopolistic competition. For purposes of our analysis we will assume that the firms in each of these market structures are price takers in resource markets and that they are producing in the short run. The result of these assumptions is that the cost curves of each firm in these industries will have the same general shape as those presented in Chapter 6. Firms differ in the proportion of total market demand that is satisfied by the production of each. This is illustrated in Figure 8.1. At one extreme is perfect competition, in which the typical firm produces only a very small percentage of total industry output. At the other extreme is monopoly, where the firm is responsible for producing the entire output of the industry. The percentage of total industry output produced is critical in the analysis of profit maximization because it defines the shape of the demand curve facing the output of each individual firm. The market structures that will be examined in this and the next chapter can be viewed as lying along a spectrum, with the position of each firm defined by the percentage of the market Perfect competition Monopolistic competition Oligopoly Monopoly FIGURE 8.1 Market structure is defined in terms of the proportion of total market demand that is satisfied by the output of each firm in the industry. 316 Market Structure: Perfect Competition and Monopoly satisfied by the typical firm in each industry—from perfect competition at one extreme to monopoly at the other. PERFECT COMPETITION The expression “perfect competition” is somewhat misleading because overt competition among firms in perfectly competitive industries is nonexistent. The reason for this is that managers of perfectly competitive firms do not take into consideration the actions of other firms in the industry when setting pricing policy. The reason for this is that changes in the output of each firm are too small relative to the total output of the industry to significantly affect the selling price. Thus, the selling price is parametric to the decision-making process. The characteristics of a perfectly competitive market may be identified by using the criteria previously enumerated. Perfectly competitive industries are characterized by a large number of more or less equally sized firms. Because the contribution of each firm to the total output of the industry is small, the output decisions of any individual firm are unlikely to result in a noticeable shift in the supply curve. Thus, the output decisions of any individual firm will not significantly affect the market price. Thus, firms in perfectly competitive markets may be described as price takers. The inability to influence the market price through output changes means that the firm lacks market power. Definition: Market power refers to the ability of a firm to influence the market price of its product by altering its level of output. A firm that produces a significant proportion of total industry output is said to have market power. Definition: A firm is described as a price maker if it has market power. A price maker faces a downward-sloping demand curve for its product, which implies that the firm is able to alter the market price of its product by changing its output level. Definition: Perfect competition refers to the market structure in which there are many utility-maximizing buyers and profit-maximizing sellers of a homogeneous good or service in which there is perfect mobility of factors of production and buyers, sellers have perfect information about market conditions, and entry into and exit from the industry is very easy. Definition: A perfectly competitive firm is called a price taker because of its inability to influence the market price of its product by altering its level of output. This condition implies that a perfectly competitive firm should be able to sell as much of its good or service at the prevailing market price. A second requirement of a perfectly competitive market is that there also be a large number of buyers. Since no buyer purchases a significant 317 The Equilibrium Price proportion of the total output of the industry, the actions of any single buyer will not result in a noticeable shift in the demand schedule and, therefore, will not significantly affect the equilibrium price of the product. A third important characteristic of perfectly competitive markets is that the output of one firm cannot be distinguished from that of another firm in the same industry. The purchasing decisions of buyers, therefore, are based entirely on the selling price. In such a situation, individual firms are unable to raise their prices above the market-determined price for fear of being unable to attract buyers. Conversely, price cutting is counterproductive because firms can sell all their output at the higher, market-determined, price. Remember, the market clearing price of a product implies that there is neither a surplus nor a shortage of the commodity. A final characteristic of perfectly competitive markets is that firms may easily enter or exit the industry. This characteristic allows firms to easily reallocate productive resources to be able to exploit the existence of economic profits. Similarly, if profits in a given industry are below normal, firms may easily shift productive resources out of the production of that particular good into the production of some other good for which profits are higher. THE EQUILIBRIUM PRICE As we have already discussed, the market-determined price of a good or service is accepted by the firm in a perfectly competitive industry as datum. Moreover, the equilibrium price and quantity of that good or service are determined through the interaction of supply and demand. The relation between the market-determined price and the output decision of a firm is illustrated in Figure 8.2. P $ D MC S P* P* B A ATC MR AVC C S D 0 FIGURE 8.2 profit. Q* Q 0 Q⬘f Q Short-run competitive equilibrium with positive (above-normal) economic 318 Market Structure: Perfect Competition and Monopoly The market demand for a good or service is the horizontal summation of the demands of individual consumers, while the market supply curve is the sum of individual firms’ marginal cost (above-average variable cost) curves. As discussed earlier, if the prevailing price is above the equilibrium price (P*), a condition of excess supply forces producers to lower the selling price to rid themselves of excess inventories. As the price falls, the quantity of the product demanded rises, while the quantity supplied from current production falls (QF). Alternatively, if the selling price is below P* a situation of excess demand arises. This causes consumers to bid up the price of the product, thereby reducing the quantity available to meet consumer demands, while compelling producers to increase production. This adjustment dynamic will continue until both excess demand and excess supply have been eliminated at P*. Problem 8.1. Suppose that a perfectly competitive industry comprises 1,000 identical firms. Suppose, further, that the market demand (QD) and supply (QS) functions are QD = 170, 000, 000 - 10, 000, 000P QS = 70, 000, 000 + 15, 000, 000P a. Calculate the equilibrium market price and quantity? b. Given your answer to part a, how much output will be produced by each firm in the industry? c. Suppose that one of the firms in the industry goes out of business. What will be the effect on the equilibrium market price and quantity? Solution a. Equating supply and demand yields 170, 000, 000 - 10, 000, 000P = 70, 000, 000 + 15, 000, 000P P* = $4.00 Substituting the equilibrium price into either the market supply or demand equation yields Q* = 170, 000, 000 - 10, 000, 000(4) = 70, 000, 000 + 15, 000, 000(4) = 130, 000, 000 b. Since there are 1,000 identical firms in the industry, the output of any individual firm Qi is Qi = Q* 130, 000, 000 = = 130, 000 1, 000 1, 000 c. The supply equation of any individual firm in the industry is Qi = Q* = 70, 000 + 15, 000P 1, 000 319 The Equilibrium Price Subtracting the supply of the individual firm from market supply yields Q * -Qi = (70, 000, 000 + 15, 000, 000P ) - (70, 000 + 15, 000P ) = 69, 930, 000 + 14, 985, 000P Equating the new market demand and supply equations yields 170, 000, 000 - 10, 000, 000 P = 69, 930, 000 + 14, 985, 000 P P* = $4.0052 Q* = 170, 000, 000 - 10, 000, 000(4.0052) = 69, 930, 000 + 14, 985, 000(4.0052) = 129, 948, 000 This problem illustrates the virtual inability of an individual firm in a perfectly competitive industry, which is characterized by a large number of firms, to significantly influence the market equilibrium price of a good or service by changing its level of output. For this reason, it is generally assumed that the market price for a perfectly competitive firm is parametric. SHORT-RUN PROFIT MAXIMIZATION PRICE AND OUTPUT If we assume that the perfectly competitive firm is a profit maximizer, the pricing conditions under which this objective is achieved are straightforward. First, define the firm’s profit function as: p(Q) = TR(Q) - TC (Q) (8.1) To determine the optimal output level that is consistent with the profitmaximizing objective of this firm, the first-order condition dictates that we differentiate this expression with respect to Q and equate the resulting expression to zero. This procedure yields the following results dp(Q) dTR(Q) dTC (Q) = =0 dQ dQ dQ (8.2) MR - MC = 0 (8.3) or That is, the profit-maximizing condition for this firm is to equate marginal revenue with marginal cost, MR = MC. To carry this analysis a bit further, recall that the definition of total revenue is TR = PQ. The preceding analysis of a perfectly competitive market reminds us that the selling price is determined in the market and is unaffected by the output decisions of any individual firm. Therefore, dTR(Q) = MR = P0 dQ (8.4) 320 Market Structure: Perfect Competition and Monopoly where the selling price is determined in the market and parametric to the firm’s output decisions. Thus, the profit-maximizing condition for the perfectly competitive firm becomes P0 = MC (8.5) To maximize its short-run (and long-run) profits, the perfectly competitive firm must equate the market-determined selling price of its product with the marginal cost of producing that product. This condition was illustrated in Figure 8.2 (right). Assuming that the firm has U-shaped average total and marginal cost curves, Figure 8.2 illustrates that the perfectly competitive firm maximizes profits by producing 0Qf units of output, that is, the output level at which P* = MC. The economic profit earned is illustrated by the shaded area AP*BC in the figure. This can be seen when we remember that p = TR - TC = P * Q f - ATC (Q f ) (8.6) This is illustrated in Figure 8.2 as Area{AP * BC} = Area{0P * BQ f } - Area{0 ACQ f } (8.7) It should be remembered that the cost curves of Figure 8.2 include a normal rate of profit. As a consequence, any time the firm has an average revenue greater than average cost, it is earning an economic profit. Definition: A firm earns economic (above-normal) profit when total revenue is greater than total economic cost. Problem: 8.2. Consider the firm with the following total monthly cost function, which includes a normal profit. TC = 1, 000 + 2Q + 0.01Q 2 The firm operates in a perfectly competitive industry and sells its product at the market-determined price of $10. To maximize total profits, what should be the firm’s monthly output level, and how much economic profit will the firm earn each month? Solution. First, determine the firm’s marginal cost function by taking the first derivative of the total cost function with respect to Q. dTC = MC = 2 + 0.02Q dQ As discussed earlier, profit is maximized by setting MC = P*, thus 10 = 2 + 0.02Q Q = 400 Economic profit is given by the expression 321 The Equilibrium Price p = TR - TC = P * Q - 1, 000 - 2Q - 0.01Q 2 = $10(400) - 1, 000 - 2(400) - 0.01(4002) = $600 Problem 8.3. A perfectly competitive industry consists of 300 firms with identical cost structures. The respective market demand (QD) and market supply (QS) equations for the good produced by this industry are QD = 3, 000 - 60P Qs = 500 + 40P a. What are the profit-maximizing price and output for each individual firm? b. Assume that each firm is in long-run competitive equilibrium. Determine each firm’s total revenue, total economic cost, and total economic profit. Solution a. Firms in a perfectly competitive industry are characterized as “price takers.” The profit-maximizing condition for firms in a perfectly competitive industry is P = MC, where the price is determined in the market. The market equilibrium price and quantity are determined by the condition QD = QS 3, 000 - 60P = 500 + 40P P * = $25 Q* = 500 + 40(25) = 500 + 1, 000 = 1, 500 The market equilibrium price, which is the price for each individual firm, is P* = $25. The market equilibrium output is Q = 1,500. Since there are 300 firms in the industry, each firm supplies Qi = 1,500/300 = 5 units. b. The total revenue of each firm in the industry is TR = P * Qi = 25(5) = $125 In long-run competitive equilibrium, each firm earns zero economic profit. Since economic profit is defined as the difference between total revenue and total economic cost, then the total economic cost of each firm is TCeconomic = $125 Problem 8.4. The market-determined price in a perfectly competitive industry is P = $10. Suppose that the total cost equation of an individual firm in the industry is given by the expression TC = 100 + 5Q + 0.02Q 2 322 Market Structure: Perfect Competition and Monopoly a. What is the firm’s profit-maximizing output level? b. Given your answer to part a, what is the firm’s total profit? c. Diagram your answers to parts a and b. Solution a. The profit-maximizing condition for a firm in a perfectly competitive industry is P0 = MC The firm’s marginal cost equation is dTC = 5 + 0.04Q dQ MC = Substituting these results into the profit-maximizing condition yields 10 = 5 + 0.04Q 0.04Q = 5 Q* = 125 b. The perfectly competitive firm’s profit at P* = $10 and Q* = 125 is p* = TR - TC = P * Q * -(100 + 5Q * +0.02Q *2 ) [ = 10(125) - 100 + 5(125) + 0.02(125) 2 ] = 1, 250 - 1, 037.50 = $212.50 c. Figure 8.3 diagrams the answers to parts a and b. ␲␲ TCTC FIGURE 8.3 problem 8.4. Diagrammatic solution to