The consequences of competition for the pricing and output decisions of firms are most easily established in the model of pure competition,1 which requires that
1. Potential buyers and sellers are numerous and each is so small relative to the market that individual decisions about purchases or output do not noticeably affect market demand or supply, nor, consequently, do individual decisions affect the market price.
2. Firms in the industry produce a homogeneous (standardized) good.
3. Barriers to entry or exit are insignificant in the long run; new firms are free to enter the industry if doing so appears profitable or exit if they anticipate losses.
Generic office supplies, most agricultural products, and a few other relatively homogeneous goods are produced in highly competitive markets. Each buyer or seller is too insignificant to single-handedly affect the total demand or supply of the good, leaving competitive buyers and sellers as quantity adjusting price takers; they have no choice but to accept the price set in the market.
Price takers are buyers or sellers who are so small relative to a market that the effects of their transactions are inconsequential for market prices.
Thus, individual competitive buyers view the supply curves facing them as perfectly elastic (horizontal) at the current market price. Similarly, competitive sellers perceive the demand curves they face as horizontal at the market price.
Competition usually connotes rivalry. We all grow up competing for grades, merit badges, positions on teams, and dates. Iowa farmers broadly compete with other farmers from all around the globe. How are prices set for their corn, wheat, or pigs? Do farmers argue that their products are superior and so should command a premium price? Clearly not. Nor do they offer coupons or instant winner bingo to compete for buyers.
Competitive price setting occurs for basic farm products (from eggs to sugar to orange juice concentrate), raw materials (coal or crude oil), primary products (steel or lumber), and precious metals (gold or silver) roughly 240 business days each year at commodity exchanges in major cities around the globe.2 Market prices are set for hundreds of commodities in an auction environment by the bids and offers of thousands of buyers and sellers or their broker representatives.
Commodity exchanges seem chaotic to visitors. Commodities are traded in a climate approaching pure competition, primarily by public outcry. Wild-eyed traders angle various numbers of fingers overhead and scream bids and offers on a huge, crowded trading floor. The din rivals that during the opening kickoff at the Super Bowl. No single buyer or seller can sway prices as bids and offers are accepted or rejected. A trader may buy cotton for a Tokyo customer one minute and sell Georgia peanuts the next, but most traders are narrowly specialized. Small farmers often sell their entire crop at the going market price in a single transaction. Farmers are examples of price takers.
If you struck gold at your sand-and-gravel site, you could sell all the gold you mined at the going market price ($600), as shown in Figure 1. The demand curve facing each purely competitive mine is a horizontal line (d) at the market price (Pe = $600). Trying to charge a price above Pe would result in no sales, while cutting price below Pe would not increase the ability to sell gold: all your output can be sold at the going price. Thus, purely competitive firms decide what amounts of output to produce and sell at current prices. Even firms mining hundreds of claims using millions of dollars worth of equipment can sell gold only at the going price. This is why pure competitors, including farmers, are price takers.
Purely competitive firms compete in one dimension: technically efficient production. They try to minimize costs while producing the level of output that maximizes profit. We will present some recipes that a firm must follow to select the output that maximizes profit, but be aware that this also requires decisions about which resources and technologies to use. Real-world decisions usually involve coping with less information than economists assume firms have when they build the purely competitive model.
• Rivalry The stress on quantity decisions by pure competitors contrasts sharply with competition among carmakers, for example. It is difficult and costly for a new firm to enter the auto market. Cars are not standardized, and the pricing and output decisions of any of the big three U.S. automakers or their foreign counterparts clearly affect the sales of other producers. Advertising, styling, and aggressive marketing are as important as pricing strategy. These firms are rivals, but unlike purely competitive firms, they do not compete solely on the basis of efficient production of output at a market-determined price.
Freedom of entry and exit is vital for competition to be effective over time.
Freedom of entry and exit means, in the long run, firms can enter an industry with no cost disadvantages relative to established firms, and established firms can costlessly transfer resources to other industries.
For example, few barriers limit entry and exit into agriculture. Prosperity invariably attracts more resources into farming. Prices and profits then fall, decreasing incentives for further entry. On the other hand, bad times in farming are signals that too many resources are in agriculture, and some farmers will shift their resources to industries that seem more prosperous.
The model of pure competition underpins supply and demand analysis, which provides fairly reliable predictions about how certain events will affect prices and outputs. Few industries match all the assumptions of pure competition, but remember that a model should be no more complex than is required for the purpose at hand; models are judged by predictive accuracy, not by realism of assumptions. Pure competition also sets the normative yardstick for efficiency used to judge other market structures. Although pure competition may be rare, rapid growth of international trade has made many markets much more competitive in recent years.
Short-Run Competitive Pricing and Output
All firms are assumed to maximize profit (the excess of revenues over costs), a process that can be described in several ways. The simplest explanation of short run profit maximization is the total revenue minus total cost (TR – TC) approach.
Total Revenue – Total Cost Approach
A pure competitor is a price taker, so how much to produce (quantity adjustment) is its major decision.3 Will producing and selling as much as possible maximize profits? The example outlined in Table 2 leads us to the answer. Suppose you can mine weekly gold output levels ranging from nothing to 12 ounces and that the market dictates a price of $600 per ounce. Whether you sell one ounce of gold or 12 ounces, each ounce currently sells for $600. The total revenue curve in Panel A of Figure 2 shows how revenue grows as output rises; its slope is constant at $600 per ounce of gold. If fixed costs are $570 weekly, the production costs associated with each output level are shown in column 4 of Table 2 and graphed in Panel A as TC.
Subtracting total costs from total revenue is a straightforward way to calculate profit. You can mine the amount where this difference, profit (π), is the largest. Look at column 5 in Table 2; producing 7 ounces of gold yields maximum profit of $1,200. In Panel A of Figure 2, profit is maximized where the vertical distance between total revenue and total costs is greatest; in Panel B, profit is maximized where the vertical distance between the profit curve and the horizontal axis is greatest. The profit-maximizing output in this example occurs at 7 ounces.
Notice that two break-even levels of output are shown in Panel A of Figure 2.
Break-even or normal profit points occur where total revenue = total cost; economic profit is zero.
These points are critical for decisions about entering risky lines of business. You would naturally like any risky activity to potentially break-even at low levels of output and sales. One lesson here is that there are two aspects of profit maximization, regardless of market structure. First consider the demand side (total revenue and price), then the supply side (production costs). Each side affects profit-maximizing output or pricing decisions, or both.
Total revenue minus total cost is easily understood. A more fruitful approach for operational decisions, however, is the marginal cost equals marginal revenue (MC = MR) approach. The total revenue minus total cost (TR – TC = π) and marginal revenue equals marginal cost (MR = MC) approaches yield mathematically identical results, but they arrive at profit maximization by different routes and provide different insights.
Marginal Revenue = Marginal Cost Approach
We discussed marginal cost in the preceding chapter. We need to analyze marginal revenue before discussing how firms link these concepts to set output at its most profitable level.
• Marginal Revenue Marginal cost is the increase in total cost incurred by producing one more unit of output. Marginal revenue is defined in a similar fashion:
Marginal revenue is the increase in total revenue from selling one more unit.
For a purely competitive firm, marginal revenue equals price (MR = P). Consider your gold mine. The price of gold is set in the international commodity market for precious metals centered in New York, London, and Zurich, so mining firms are price takers. If the going rate for gold is $600 per ounce, a firm’s marginal revenue is $600 per ounce sold, regardless of how many ounces individual firms sell. Remember that each gold mine is too insignificant to affect the total market price or output. Return for a moment to Figure 1. Each mine operator views the demand curve faced as horizontal at the $600 price. Each firm’s perception of demand curves as perfectly elastic means that each mine operator expects total revenues to be exactly proportional to output, because price is fixed and total revenue equals price times quantity. Thus, because the price is unaffected by the amounts sold by any firm, each ounce of gold is expected to generate marginal revenue equal to $600.
Review the data in Table 2. Column 2 reveals the market price to be $600 per ounce. Marginal revenue is the change in total revenue from the sale of one more unit, so as we go from 5 ounces to 6 ounces of gold sold, total revenue jumps from $3,000 to $3,600 weekly for a net change of $600.
Marginal revenue equals the price (MR = P) of the commodity in competitive markets.
Our next order of business is determining how competitive firms use this price and cost information to maximize profits.
• Profit Maximization Suppose you have information about the marginal cost and the price of each unit of output. How much should be produced and sold? One rule of thumb for any firm (regardless of industry structure) might be to make any small adjustment (including the production of an additional unit of output) that brings in at least as much in revenues as it absorbs in costs. This translates into economic jargon as the
Marginal revenue = marginal cost rule: All profit-maximizing firms produce and sell an extra unit of output only if marginal revenue is at least as great as marginal cost.
Your revenue from selling one more unit of gold (from Table 3) is graphed in Figure 3 as the demand curve d (P = MR = $600). Marginal cost from your cost data (column 7 in Table 3) is graphed as the MC curve in Figure 3. Consider what happens when you produce and sell the seventh ounce of gold. The extra revenue to your firm is $600, but the seventh ounce of gold only costs $590 to produce. Thus, extra profit from the sale of this seventh unit is $10. In fact, you will increase total profit by the blue triangle below the demand curve as you increase output from 6 to 7 ounces.
What would happen to profit if you produced the eighth ounce? You would receive only $600 for it, but its production costs would be $690. You will lose $90 on the eighth ounce if you produce and sell it. Your profit will fall by the area of the reddish triangle above the demand curve as output rises from 7 to 8 ounces.
Conclusion? Price and marginal revenue are identical in pure competition, so a profit-maximizing pure competitor produces where marginal cost equals price: P = MR = MC, which in this example occurs at 7 ounces. This analysis leads to profit-maximization rule that holds for firms ranging from pure competition to pure monopoly: All profit-maximizing firms produce and sell until marginal cost just equals the marginal revenue (MR = MC) derived from the sale of the good.
Marginal revenue and marginal cost data for your gold mine (from Table 3) are graphed in Figure 4, along with average total cost. The marginal revenue equals marginal cost approach reveals that 7 ounces is still the profit-maximizing output level (point e). The TR – TC approach provides one way to compute total profit. Total revenue equals price times quantity; for 7 ounces of gold at $600 per ounce, this is $4,200.
Geometrically, this is the area 0ceg in Figure 4. But how much is total cost? Since average total cost for 7 ounces is $428.58 for each ounce (point a), the total cost for all 7 ounces is $3,000 ($428.58 7 = $3,000). The area 0bag geometrically represents total cost (average cost times quantity). Thus, total weekly profit is $1,200 ($4,200 – $3,000), which is the blue area bcea in Figure 4.
An alternative way to compute total profit is to multiply average profit per unit times output. Price minus average total cost (P – ATC) equals average profit per unit, so average profit per unit when 7 ounces are produced is the distance ae in Figure 4, which is $171.42 ($600 – $428.58). Thus, total weekly profit is still $1,200 ($171.42 7, the shaded area bcea, which also equals TR – TC). Whether we maximize total revenue minus total cost or use the marginal revenue equals marginal cost approach, the mathematical solution is the same for the firm’s profit-maximizing decision.
Figure 4 also shows what happens if the price of gold falls sharply. At roughly $385 per ounce, marginal revenue equals marginal cost at point f, or an output level of roughly 5 ounces. Average total cost, however, is in the $380 range, so the firm barely breaks even at a $385 price per ounce of gold. The lowest break-even or normal profit price in a competitive industry occurs when the demand curve facing each individual firm (the price line) is tangent to the minimum point of the firm’s average total cost curve. Remember that zero economic profit means the firm generates positive accounting profits just sufficient to keep the firm’s owners satisfied. Typical firms will neither incur economic losses nor enjoy economic profits at such a price, so there will be no net tendency for the industry to shrink or grow because of entry and exit. In a moment you will see that this break-even situation characterizes firms in purely competitive industries in long-run equilibrium.
Measuring profits may seem a precise process, but decisions must be made even though managers never perfectly predict the profit yielded by any decision. What matters is the direction of change: will profit rise or fall if a firm adopts a certain policy? Expected marginal benefits and costs are crucial for all types of decisions. For example, when public policy decisions are made about tax structures, incentive systems, or various regulations, the same kinds of questions arise: if a specific policy were altered, in what direction would social welfare, net consumer satisfaction, or business profits change? If decision-makers know this, they can adjust toward optimal policies.
• Loss Minimization and Plant Shutdown Alas, business is not always profitable. One of two choices must be made if sales revenues cannot cover all costs. The firm will experience losses if it elects to produce and sell output. If the firm shuts down, however, it incurs losses equal to fixed costs. Which decision will yield the smaller loss?
Suppose the demand for gold collapses, dropping its price to $300 per ounce, as reflected in Figure 5. Should you mine any gold? Our rule that a firm maximizes profit or minimizes loss by equating marginal revenue and marginal cost seems to indicate that optimal weekly output in this instance is 4 ounces (point e). At this level of output, total revenue (area 0aeh, or $1,200) fails to cover total costs (area 0bch, or $1,530), yielding a loss (area abce, or $330 weekly). The result is the same if we apply an average revenue minus average cost approach to this situation. In Figure 5, average revenue (price) is $300 at point a, while average total cost is $382.50 at point b. Thus, the average loss per unit of output of $82.50 times 4 ounces yields a total loss of $330 (the reddish area abce in Figure 5).
Suppose you closed the mine to avoid selling gold below its average total cost. Losses would equal fixed costs: the entire $570, or area gbcf, in our example. Remember that fixed costs are incurred whether or not any output is produced. These include such expenses as rent payments, utility charges (for minimum service), administrative overhead, and insurance. Fixed (sunk) costs are not current opportunity costs because they cannot be avoided; the alternatives they once represented were lost in the past. Thus, exiting this competitive industry is virtually costless in the long run.
Variable costs are a firm’s opportunity costs of production. Average variable costs of $240 (point f in Figure 5) are incurred in wages, materials, and other expenses when 4 ounces of gold are mined. Consequently, average variable costs will be covered as long as the mine can sell gold for more than $240 per ounce. As the mine operator, you might allocate the difference between price ($300) and average variable costs ($240) to a fund to cover fixed costs. Even if all fixed costs were not covered, some could be; a loss of $330 is better than a loss equal to fixed costs of $570. Note that the critical costs to cover are variable costs, not fixed costs. As the saying goes, sunk costs are sunk.
When will it pay the firm to shut down? The answer is that a firm will be ahead by closing its doors if the price of a good fails to cover its average variable costs. This is shown in Figure 6. You should close the mine if the price of gold falls below $215 per ounce, which is the minimum value of the average variable cost curve (point e). At a price of $215, the mine just recoups its variable costs from the sale of 2 ounces of gold weekly because variable costs are $215 per unit for labor, materials, and so forth. Consequently, total losses are $570 (area abce) whether 2 ounces of gold are produced and then sold for $215 or not; nothing is contributed to fixed costs from the production and sale of these units.
What happens if gold falls below $215 per ounce, to, say, $200? If the mine produced 2 ounces of gold, in addition to $570 in fixed costs, you will lose at least $15 more per ounce, yielding total losses of $600 [$570 + ($15 2)]. Operating at all would not minimize your losses. If the price falls below $215, temporarily abandon the mine. Thus, a $215 price corresponds to the mine’s shutdown point. It is the lowest price that will induce you to operate, and you will try never to mine less than 2 ounces of gold.
Shutdown point: Profit-maximizing (and loss-minimizing) firms shut down when the market price falls below the minimum point of the average variable cost curve.
Take a moment to compare Figures 4, 5, and 6. Note that profit can be realized if the demand curve (price line) facing a firm intersects its ATC curve. Unfortunately, short-run losses are inevitable if the firm’s ATC curve lies above the demand curve at all output levels. In a moment, you will see that if the demand curve is exactly tangent to the ATC curve, the best the firm can do is earn normal profits. Figure 7 summarizes the short-run operating rules for purely competitive firms.
Our analysis so far suggests that the first question every profit-maximizing firm confronts, regardless of market structure, is whether to operate in a market. If the demand curve it faces has any segment that is above its average variable cost curve (which, among other costs, must reflect the values foregone from alternative types of production), then it will operate in that market. If operation in a market is profit-maximizing (or loss minimizing), then a second question addresses how much to produce; the answer is that profit is maximized when marginal cost equals marginal revenue. We now examine the nature of the short-run firm and industry supply curves.
• Short-Run Supply Curves of Purely Competitive Firms You may have deduced that a competitive firm’s marginal cost curve is also its short-run supply curve as long as price exceeds the minimum point of the average variable cost curve. These points on a marginal cost curve reflect the profit-maximizing outputs corresponding to various market prices for the good. If price falls below minimum average variable costs (AVC), marginal costs and marginal revenue become irrelevant; the firm’s best move is to close its plant and suffer losses equal to fixed costs. However, whenever the price exceeds the shutdown point (the minimum AVC), the firm minimizes losses or maximizes profit by supplying the amount of output where P = MR = MC. This is a firm’s short-run supply response.
A pure competitor’s short-run supply curve is the segment of the marginal cost curve that lies above the minimum point of the firm’s average variable cost curve.
This is shown in Figure 8. When price and marginal revenue equal P0, this firm supplies only q0. As the price rises, the firm increases the amount it supplies to maximize profit or minimize loss by equating that price with marginal costs, so if price increases to P1 and P2, the firm will supply q1 and q2, respectively. Now let us see how individual firm’s supply curves are combined to form an industry supply curve.
• The Short-Run Industry Supply Curve A competitive industry contains numerous firms, so there is a predictably tight relationship between the industry supply curve and firm supply curves. Consider, for simplicity, an industry comprised of two firms with individual supply curves as shown in Panel A of Figure 9. When the market price is $1, the first firm will supply 10 units and the second firm will supply 30 units. Together, they supply 40 units at the $1 price, as plotted in Panel B. This process is called horizontal summation.
The short-run industry supply curve is the horizontal sum of the supply curves of all firms in a purely competitive industry.
We simply add the quantities produced by each firm at each possible price to arrive at the industry short-run supply curve. You can verify this graphically by adding together the quantities that each firm will turn out at various prices, and you will see that these total quantities supplied conform to those plotted in Panel B.
We have now related individual and market supplies. The output decisions of individual firms, when summed, determine the market supply schedule. This market supply, in concert with consumers’ demands for a good, determines the market-clearing price. An industry is in equilibrium when firms supply all they are willing to at the going price and consumers can buy all they desire at that price. All firms maximize profit by producing where MR = MC. Firms minimize losses by shutting down if price fails to cover AVC.
• Supply Responses and Time All decision-makers gain flexibility as the time horizon expands. Industry responses to shifts in demand depend in part on how long firms have to adjust. Alfred Marshall, designed a systematic way for economists to treat time conceptually. Responses are classified as occurring in the market (immediate) period, the short run (SR), or the long run (LR). The more time an industry has to adapt to changes in demands, the greater are quantity adjustments and the smaller are price adjustments. Thus, the market elasticity of supply is positively related to the time allowed for an industry to adjust. In the market period, supply is purely inelastic because we assume, for simplicity, that neither resources nor inventories can be adjusted. Supplies are somewhat elastic in the short run and even more elastic in the long run.
This relationship is shown in Figure 10. Suppose the original demand for gold is D0, where price is $600 and quantity sold is Q0. If demand rises to D1, gold would rise to $850 per ounce during the market period to reflect mining firms’ temporary inability to boost output. If the higher demand persists, mines might boost output by paying overtime wages, hiring new workers, or through other short-run devices. This rise in quantity supplied by existing firms yields a short-run price of $725, which is below the price of $850 per ounce immediately after demand rose to D1. But prospectors will ultimately find more gold; as owners of new mines respond to higher profits, supplies will rise further, reducing the long-run equilibrium price to $650.
The range of potential adjustments in an industry expands when firms have more time to adapt. In the long run, quantities adjust more and price adjusts less for a given change in demand than in the market period or the short run. Firms cannot modify output in a single market period to minimize losses or to exploit new profit opportunities when demands change.
Firms can only partially adjust in the short run, because at least one resource is fixed. Only in the long run are all resources variable so that firms can enter or leave markets as their owners choose. Given sufficient time, technology may even improve as miners seek new ways to exploit the higher market demand and price of gold.
What role does profit play in the longer run? What happens if new firms enter an industry? If technological breakthroughs substantially reduce production costs? These and other issues are examined in the next section as we step from short-run to long-run adjustments in purely competitive industries.
Long-Run Adjustments in Purely Competitive Industries
The number of firms in any industry is fixed in the short run, but in the long run, the most important characteristic of competition is freedom of entry and exit. The number of firms in an industry may rise with entry of new firms or fall as existing firms fail or move into different product lines. Economic profit attracts new firms to an industry, while economic losses signal owners to liquidate existing firms or to look for new product lines. Entry into prospering industries and exit from those that are faltering is basic to the smooth operation of a market economy and to accommodating consumers’ priorities.
Economic Profits as Market Signals
Economic profits are a surplus after all implicit and explicit costs of production are subtracted from total revenue. Thus, average total costs include allowances for the opportunity costs of the entrepreneurial talents and capital a firm uses, among other things. Normal economic returns to these resources must be earned. Economic losses push a firm’s owners into moving their resources into other activities. On the other hand, if revenues exceed all costs, a firm may try to expand in an attempt to capture as much economic profit as possible. In a sense, however, economic profit ultimately self-destructs by attracting new competitors into the industry.
Suppose the markets for statues and for potted plants are both in equilibrium and that both are homogeneous products. Economic profits are zero for all firms in both industries. Then the demand for indoor plants plummets as interior decorators unite to convince people that plants are passé and that no corner in any room is complete without an imitation Greek statue. Statue makers are deluged with new orders, while florists and garden shops throughout the country watch their sales wilt. Specials and discounts become the order of the day in the houseplant industry, and short-run economic losses occur as prices, outputs, and total revenues decline. On the other hand, the prices and outputs of statuary soar and economic profits are widespread in the short run.
In the long run, resources migrate from the houseplant industry. New investment declines, and florists train for other work as floral shops fold. Investment gravitates into statuary making as new firms flock to the industry in search of profits, and more workers become statue makers. Thus, over the long run, competition eliminates both economic losses in the plant industry and economic profits in statuary; plant prices recover from their depressed state, and statue prices fall from their short-run peaks. At the final equilibrium along the long-run supply curves for each industry, firms realize only normal (zero) economic profits, and all opportunity costs are covered by revenues.
Let us discuss market adjustments in more detail. The long run allows all resources (including capital) to enter or leave an industry. New firms move into growing industries, while existing firms wither or die in declining industries. Thus, we expect resources to flow from less profitable toward more profitable industries. Entry and exit from highly competitive industries can be accomplished with ease. Many hit-and-run competitors jump into profitable markets and leave as soon as other markets appear more profitable. This hit-and-run pattern is socially beneficial because it ensures that even erratic consumer demands are accommodated quickly.
The Process of Competition
Social gains from competition depend heavily on freedom to enter or exit markets as firms seek profit or try to avoid loss. If typical firms make zero economic profits, then (all else being equal) there will be no long-run changes in the number of firms in the industry, the amount of output supplied, or the price of the good. Recall that normal returns to capital owners and entrepreneurial talent are economic costs to the firm. Zero economic profits mean that all costs are covered, that is, the firm’s resources cannot be used more advantageously elsewhere.
Zero, or normal, economic profit is a long-run equilibrium condition for firms in a competitive industry. The output, price, and number of firms in the industry will all be stable.
To summarize, in a long-run equilibrium, no pure competitor will want to
1. change its output, because price equals marginal cost (P = MC).
2. change its plant size, because short-run average total cost equals long-run average total cost (SRATC = LRATC).
3. enter or leave the industry, because price equals long-run average total cost (P = LRATC).
But if most firms in an industry experience economic profits, competitive pressures tend to eliminate these profits over time, because prices will fall or costs will increase. Conversely, economic losses tend to cause prices to climb or costs to decline, or both.
• Price Changes Eliminate Economic Profits or Losses If firms in an industry earn positive economic profits, existing firms try to capture greater profits by expanding capacity and output. Entrepreneurs outside the industry also have incentives to enter these markets in the long run. Both types of adjustments increase an industry’s output, reducing prices because consumers will increase their purchases only if prices decline.
On the other hand, if most firms in an industry experience economic losses, then some will cut their production, and in the long run, the firms with the highest opportunity costs (best alternative uses of their resources) will leave the industry. Thus, the long-run effects of economic losses are that the industry’s supply will decline and prices will rise.
• How Profits or Losses Affect Costs Competition will grow for the resources used by a profitable industry. If supplies are perfectly elastic for all resources used by an industry, production can expand without driving up average production costs. Resource costs will rise as production in an industry rises, however, to the extent that some resources are especially suited for certain industries and not others. For example, what do you think happens to the costs of acquiring oil drilling rights as the price of oil balloons? What happens to the prices of agricultural land when food prices soar? Costs rise to reduce profits in both cases.
The following is another example of how rising costs eliminate profits: if your firm enjoyed extremely high profits because it hired an exceptionally efficient management team, might some competitor try to hire members of this team? What would happen to their salaries?
The market forces that raise costs in an industry in which most firms make economic profits also lowers costs in instances where most firms incur losses. Both average costs and marginal costs rise in profitable industries and shrink when economic losses are the norm. To simplify the analysis in the following discussion, we focus only on price (not cost) adjustments. Remember, however, that changes in either prices or costs will eliminate economic profits or losses in competitive markets in the long run. Moreover, we assume in the following discussion that prices adjust smoothly toward long-run equilibrium. You should recognize that some firms may overreact in unison to economic profits or losses, so that prices may swing somewhat before ultimately converging on their equilibrium values.
Long-Run Equilibrium in a Purely Competitive Industry
Firms operate close to capacity in highly profitable industries, but if business conditions go sour, they slash production. Consider the industry shown in Figure 11. This industry is in short-run equilibrium before the entry of new firms. Industry demand and supply are D0 and S0, respectively, and industry output equals Q0; each firm produces an output of q0, where P0 = MR = MC. Typical firms in this industry make short-run economic profits equal to the blue area, causing firms to willingly incur higher than minimal per unit costs as they produce extra output to exploit profit opportunities.
Pure competition allows easy entry, so this is a short-run situation, because external entrepreneurs will seek shares of these profits. New firms will swell industry supply to S1, with a higher output, Q1, and a lower equilibrium price, P1. But observe what happens to each individual firm. As prices decline, each firm adjusts to a new profit-maximization output (q1) below the original level (q0). Our industry consequently now contains more firms, but the absence of profit leaves each producing less than before.
What happened to profit? Each firm previously in the industry was earning positive profits. Entry reduces prices and the amounts that each firm produces. Economic profits shrink to normal levels (zero economic profits) because the price falls to the minimum of long-run average total costs (LRATC, point e). Remember that the resources a firm’s owners provide have opportunity costs that are included in average total costs. Accounting profits are not zero in the industry; they are simply at normal levels—just high enough so that the owners earn as much in this industry as in their next best option.
You may wonder whether symmetric exit adjustments occur in unprofitable situations. Such adjustments are illustrated in Figure 12, which shows individual firms initially encountering short-run losses. Price is originally at P0, which is below average total cost (ATC0) but above average variable costs (not shown in the figure), because firms are continuing to operate. Losses are equal to the reddish area. The least efficient firms incur the largest losses and will fold or move into a different activity. Industry supply will shrink as these firms leave the industry, so the price will rise and losses will be eliminated. Profits might temporarily reappear if enough firms leave, curtailing the exodus of firms. Ultimately, however, price rises to P1 and profits return to normal levels (point e). Notice that this is just the opposite of the adjustment process described in the profitable situation just considered. Industry output falls, but individual firm’s output grows as the price recovers to normal levels when some firms exit the industry.
At the ends of periods with economic losses or profits, why does profit settle at normal levels (zero economic profits)? A moment’s reflection should provide the answer. Competitive theory presumes that entry and exit are virtually costless, so the logical stopping point occurs when each firm in the industry earns only normal profits. All opportunity costs are covered, so the owners of existing firms know of no opportunities for their resources that are more profitable, nor do entrepreneurs outside the industry perceive profit opportunities in the industry. Only then will there be no net incentives for firms to enter or leave the industry.
Another important result of long-run competitive adjustments is that all firms in the industry are forced to adopt the most efficient technology available. This is shown in Figure 13. Long-run pressures will force the price of the product to PLR because pure competition forces each firm to the lowest point on the LRATC curve. Any firm not adopting the technology and amounts of capital that yield the lowest minimum short-run average total cost (SRATC) curve will earn less than normal profits and will founder in the long run. No firm stays in any industry if it suffers sustained economic losses. Since P = MC = ATC in the long run, the ultimate equilibrium point is the lowest point on the LRATC curve, which is also the lowest point on the relevant SRATC curve. This means that outputs in competitive markets will be produced at the lowest possible long-run average total cost. Hence, competition yields both technical and allocative economic efficiency. As you will see in a later section, this result has profound implications for maintaining competition in a free market economy.
Long-Run Industry Supply Curves
Now that you know a bit about competitive adjustment processes, we can examine the long-run supply curve for the entire purely competitive industry. Horizontal summation of existing firms’ short-run supply curves yields the short-run industry supply curve. The long-run industry supply curve reflects the effects on output as entry and exit occur in response to changes in demand. The industry is in long-run equilibrium only after all desired entries and exits have occurred so that active firms realize only normal profits.
Changing demands, technologies, and products cause erratic swings in many industries. The economy continually gropes toward equilibrium, but full equilibrium may never be attained in most industries. Even so, short-run and long-run equilibria remain valuable concepts because of their analytical convenience and their predictive power. Without these notions, we have analytical mush; there are no reference points from which to compare other periods or to predict the eventual trends of outputs and prices. Long-run industry supply curves can take three general forms: (a) constant costs, (b) increasing costs, and (c) decreasing costs. We will examine each of these.
• Constant Cost Industries The long-run supply (LRS) curve of a constant cost industry is illustrated in Figure 14.
In a constant cost industry, average production costs are unaffected if the market demand shifts and the number of firms in the industry changes.
As demand grows from D0 to D1 to D2, long-run responses are increases in short-run supplies from S0 to S1 and S2, respectively, as the number of firms in the industry grows proportionally with demand. As entry occurs, long-run average costs are the same for new entrants as they are for established firms. All cost curves for individual firms are identical; the number of firms in the industry adjusts proportionally as demand changes. Thus, the long-run supply curve for a constant cost industry is perfectly elastic. An industry can expand with constant equilibrium price and costs only if technology and the costs of the resources it uses are not affected.4
• Increasing Cost Industries Industries deviate from the constant cost model for several reasons. The requirement that input prices not rise as an industry’s output rises is especially difficult if an industry relies on limited supplies of specialized resources; larger amounts of these resources can be made available only at ever higher costs. This characterizes increasing cost industries.
In an increasing cost industry, average production costs rise as market demand and the number of firms in the industry grow.
In an increasing cost industry, growth of market demand pulls up resource costs, and the average total cost and marginal cost curves for each firm in the industry rise. Thus, demand growth shifts up the long-run break-even points for each firm as minimal long-run average total costs rise, as shown in Figure 15.
If industry demand grows from D0 to D1, the industry expands as new firms enter. Competition for resources drives the short-run supply curve to S1 and the equilibrium price to P1. Rising equilibrium costs and prices yield a positively sloped long-run supply (LRS) curve. Higher prices to cover the higher resource costs allow provision of greater quantities to the market. Moreover, these rising costs cause fewer firms to enter the industry than would enter constant cost industries experiencing similar growth of demand.
Regardless of the extent of competition, most industries are characterized by increasing costs in the long run. For example, our domestic oil industry faces increasing costs in attempts to boost petroleum production. Most readily accessible crude oil has been depleted. Higher oil prices induce landowners to charge more for drilling rights. Future oil supplies will be drawn from deeper wells or high-cost locations (offshore drilling or Alaska). Alternatively, Americans may try other energy sources, most of which are much more costly than oil. This is also true for fine furniture as quality hardwood forests are depleted.
• Decreasing Cost Industries One industry’s growth may stimulate efficiencies in complementary industries. For example, mass production in the auto industry early in this century stimulated a flock of support industries: tires, batteries, gasoline and oil, and so on. As these support industries grew and implemented new technology, their average cost curves shifted downward, supplying intermediate products to the auto industry at lower prices. Car prices dropped. In the 1980s, the expansion (and increased power) of personal computers led to a growing market for sophisticated software. As the installed base of personal computers exploded, software power grew while prices fell.
In a decreasing cost industry, average production costs fall as market demand and the number of firms in the industry grow.
Thus, in a decreasing cost industry, growing demand yields lower equilibrium prices as an industry’s output expands, as shown in Figure 16.
In rare circumstances, a few industries might experience decreasing costs, but most industries eventually encounter increasing costs, so growing demand yields higher prices in the long run. The possibility that technological advances may be spurred by the search for profits, however, means that some industries may experience decreasing costs in the very long run. This seems to be true of many high-tech products today.
Evaluating Competitive Markets
Some important points in this chapter are useful in evaluating competition:
1. Pure competition is characterized by freedom of entry and exit by firms that are price takers and quantity adjusters.
2. A pure competitor maximizes profit or minimizes loss by producing the level of output that equates price, marginal revenue, and marginal cost (P = MR = MC).
3. In the long run, pure competitors use the most efficient technology available, and MC = P.5 This will also be the minimum point on the LRATC curve, because the long-run dynamics of entry and exit drive economic profits to zero regardless of whether the industry is characterized by constant, increasing, or decreasing costs.
In the long run,
P = MR = MC = SRATC = LRATC
and profits will be at normal levels, or zero economic profit.
In a purely competitive market, firms employ resources until the marginal cost of the last unit of a good equals its price. In the absence of external costs (e.g., pollution) or external benefits (e.g., education, inoculations), the opportunity cost to society of these resources equals the marginal cost of the resources to producers. If there are no externalities (discussed in depth in a later chapter), these resource costs equal their marginal social costs (MSC), that is, the value to society of the resources used to produce one more unit of a good. Competition through freedom of entry and exit ensures that this is at the lowest possible average cost and that there is no waste in production. A purely competitive economy is an efficient economy, both allocatively and technically. One aspect of economic efficiency is that all goods must be produced at their lowest possible opportunity cost (technical efficiency). Competition meets this requirement by ensuring production at minimal LRATC. Allocative efficiency requires the mix of goods produced to match consumer preferences. Here again, competition meets the criterion because consumers get the products they want at the least opportunity cost.
Positive economics cannot directly address the fairest way to divide the pie. However, if we assume that the proper distribution of income is a normative problem best settled in the political arena and that the resulting outcome is acceptable, then the competitive market system is not only efficient, it also maximizes social welfare. Here is why.
Your demand curve for any good is based on the marginal benefits (utility) that you would receive from consuming various possible amounts of the good, as we discussed in our consumer choice chapter. Our assumptions imply that the marginal utility you receive from consuming is also the marginal benefit society receives. That is, your gain is also society’s gain because you are a member of society. When we sum all consumer demands, we derive the market demand curve for an industry’s product, which is also the marginal social benefit (MSB) to all of society from having a bit more of the good.
With consumer benefits and producer costs in mind, we can refer to the industry supply and demand curves, respectively, as the marginal social cost (MSC) and marginal social benefit (MSB) curves. When a purely competitive industry is in long-run equilibrium, marginal social cost equals marginal social benefit (MSC = MSB). The industry is producing where the marginal social benefit from the last unit produced is just equal to the marginal social cost of the resources needed to produce that unit of product. This concept is illustrated in Figure 17.
The MSB = MSC condition is optimal from society’s point of view. Since the opportunity costs of resources represent alternatives for all of society, we want our resources to be used as efficiently as possible. If production were inefficient, then it would be possible for some people to gain without imposing losses on others.
Consider output level Q0 in Figure 17. The social benefit from a bit more output than Q0 is P0 (point b), which greatly exceeds the marginal cost (P1) of the resources required to produce a little more of the good (point a), so society as a whole could gain if more resources were used to produce more of this good. And in a purely competitive industry, they will be. If Q0 were initially produced and sold at price P0, existing firms would enjoy economic profit. This would cause the industry to grow until equilibrium output Qe is reached at a price and (average and marginal) production cost of Pe (point e). The adjustment process is just reversed if industry output exceeds Qe. Purely competitive markets tend to squeeze the last bit of gain possible from the resources available.
Some economists who believe strongly in competition as an effective and desirable allocative mechanism are convinced that the model of pure competition grossly understates the virtues of the market system.
Decentralized Decisions and Freedom
Most advocates of the market system point to the economic efficiency of competition as its major virtue, but prize even more the absence of any need for a central economic authority. The ideas of Adam Smith and other early advocates of capitalism were forged during a period of revolt against the dictates of monarchs of their era. Isaac Newton had observed movements of the planets and stars and concluded that natural forces generate a stable and orderly universe. Smith perceived that the invisible hand of the marketplace had similarly beneficial effects and that the iron fist of government was exercised far too often. In a truly competitive market system, each household and firm make decisions that, in large measure, affect only themselves. This diffusion of power limits the power of some individuals over other individuals. According to proponents of relying on the marketplace rather than government, this diffusion of coercive power allows the maximum possible personal freedom for everyone.
Leon Walras elaborated with mathematical precision Smith’s ideas about how people’s wants are accommodated in a competitive market system, and Vilfredo Pareto developed a concept of economic welfare that still dominates economic analysis. Pareto also proved that a purely competitive equilibrium is efficient and that other equilibria fail to maximize social welfare. Efficiency and the absence of centralized coercion are major reasons why purely competitive markets are the ideal against which we measure industrial performance. From society’s point of view, it might seem desirable that all industries be competitive so that Adam Smith’s invisible hand would yield the results we have described. Competition and access to markets may, however, be very limited if technology dictates that large firms, relative to market demand, will be most efficient.
Some Shortcomings of Market Economies
Many industries are far from competitive—in some, competition may be impractical. For example, competition among electric utilities would probably create inefficiencies because of the type of technology used. (People don’t want multiple electric lines down their streets.) In other cases, lack of competition is a consequence of illegal collusion or government policies to protect other goals (patents, medical licensing to protect the public health, and so on).
Even if the economy were quite competitive, there might still be problems of fraud, information asymmetries, inequity in the distributions of income and wealth, or externalities that the market would not resolve in ways society deems appropriate. Moreover, certain goods will not be provided optimally by a private market system. Atomic bombs, police services, and legal decisions are examples of items no society would want sold to the highest bidder.
Some economists also argue that because research and development have such important spillover benefits to the entire economy and often require bigness, such efforts might be less than optimal if left to small, competitive firms. Finally, there are questions about what social restrictions, if any, should be imposed on trade between people in different countries. The tools you have learned to use in the last few chapters will help you examine the outcomes of private market behavior and assess corrective government policies for these specific problems.