Technical and Application Questions / Economics for Managers (13 questions)

User Generated

fgbarvap

Business Finance

Economics for Managers

Description

Utilizing the attached PDF, answer the following questions that are included in the PDF:

  1. Work the following problems in Chapter 7: Technical questions 1, 2, 3, 4, 5, and 6.
  2. Work the following problems in Chapter 7: Application questions 2 and 3.
  1. Work the following problems in Chapter 8: Technical questions 4 and 8.
  2. Work the following problems in Chapter 8: Application questions 2, 3, and 4.

Unformatted Attachment Preview

7 Market Structure: Perfect Competition I n this chapter, we begin our discussion of market structure, or the environment in which firms operate. This discussion integrates demand and pricing material with production and cost issues (Chapters 3, 4, 5, and 6). You have learned that there are four major forms of market structure: perfect competition, monopolistic competition, oligopoly, and monopoly. The perfectly competitive firm has no market power because it cannot influence the price of the product. On the other end of the spectrum is the monopoly firm that has market power because it can use price and other strategies to earn larger profits that typically persist over longer periods of time. Between these two benchmarks are the market structures of monopolistic competition and oligopoly. Firms have varying degrees of market power in these market structures that combine elements of both competitive and monopoly behavior. Managers are always trying to devise strategies that will help their firms gain and maintain market power. If, and how, they can do this depends on the type of market structure in which their firms operate. We begin this chapter with a case study that describes the operation of the potato industry, an industry that contains the essential elements of the model of perfect competition. We discuss reactions of different potato farmers to changes in industry prices, attempts by potato farmers to coordinate the amount of potatoes they produce, and legal challenges to this coordinated activity. We also describe how changes in tastes and preferences and government regulations have influenced the demand for potatoes and the fortunes of the industry. We then discuss the model of perfect competition in depth. We end the chapter with a discussion of managerial strategies in several additional highly competitive industries that shows how firms in all of these industries attempt to shield themselves from the volatility of the competitive market. 200 M07_FARN0095_03_GE_C07.INDD 200 13/08/14 1:36 PM Case for Analysis Competition and Cooperative Behavior in the Potato Industry In 1996 there was a major increase in the supply of fresh potatoes, which drove potato prices from $8 per 100 pounds in 1995 to between $1.50 and $2 per 100 pounds in 1996, a price that was one-third the cost of production. Based on the substantial profits they had earned with their 1995 crops, farmers increased production in 1996, resulting in a 48.8-billion-pound crop, the largest in U.S. history.1 This was typical behavior in the potato industry where individual potato farmers let the market determine the price they obtained for their crops. High prices caused farmers to overproduce, which drove prices down below the costs of production for many farmers, making the industry unprofitable. Each farmer typically tried to gain market share under the assumption that other farmers would have a small crop due to weather, frosts, pests, or some other natural disaster. If growing conditions turned out favorable, the increased supply of potatoes pushed prices down, causing financial hardship. Idaho farmers had some competitive advantage in the markets for bagged potatoes in supermarkets and for baked potatoes in restaurants. Their potatoes often sold for a premium price of $2 or more per 100 pounds as a result of brand name recognition. Thus, Idaho producers gained some market power in these segments by turning an undifferentiated product into an identifiable brand.2 In September 2004, Idaho potato farmers formed a cooperative, United Potato Farmers of America, to help manage supply in the potato industry to keep prices high and increase profits.3 The group expanded nationally and recruited farmers from California, Oregon, Wisconsin, Colorado, Washington, and Texas. In 2005 United Potato helped take 6.8 million hundred-pound potato sacks off the U.S. and Canadian markets, which helped increase open-market returns 48.5 percent from the previous year. Each year United Potato’s board of directors would meet before planting season to decide whether farmers were on track to overproduce and to set a target for acreage reduction based on reports from the field and input from analysts. The cooperative was successful in its first years of operation. However, some growers expressed concern about whether the cooperative could maintain its control over supply and whether most of the benefits of the organization flowed 1 Stephen Stuebner, “Anxious Days in Potatoland: Competitive Forces Threaten to Knock Idaho from Top,” New York Times, April 12, 1997. 2 Stuebner, “Anxious Days in Potatoland.” 3 Timothy W. Martin, “This Spud’s Not for You,” Wall Street Journal (Online), September 26, 2006. only to Idaho producers. Potato growers serve different customers. French fry producers typically have contracts with food companies that set production levels and prices, whereas many other farmers sell their product on the open market. United Potato argued that its behavior was legal under the Capper-Volstead Act that exempted farmers from federal antitrust laws and permitted them to share prices and control supply. However, in 2010 plaintiffs representing consumers who bought fresh or processed potatoes filed suit against United Potato and other cooperatives charging that they violated the Capper-Volstead Act by operating as a price-fixing trade group rather than a legitimate cooperative.4 The plaintiffs wanted compensatory and punitive damages, court costs, and a court order for defendants to surrender profits that resulted from their illegal conduct. In December 2011, a federal judge denied a motion to dismiss the antitrust conspiracy claims even though the cooperatives continued to argue that their behavior was permissible under the Capper-Volstead Act. The court issued an advisory opinion that the Capper-Volstead Act permitted concerted action after production but not coordinated action that reduced acreage for planting before production. There have also been changes in the demand for potatoes that have caused problems for potato farmers. The U.S. Department of Agriculture reported that, after a decade of phenomenal growth, U.S. consumption of french fries was expected to decrease 1 percent in the fiscal year ending June 30, 2002.5 Most of this decrease was anticipated to result from slower expansion of the fast-food industry due to market saturation and increased numbers of outlets, such as Subway restaurants, that do not sell french fries. U.S. exports of fries have also slowed, given a saturated Japanese market and the difficulties U.S. firms face in entering the Chinese market. The U.S. Department of Agriculture has also developed a fry made from a rice flour mixture that absorbs 30 percent less oil when cooked and could become a substantial competitor to the traditional french fry in the future. Although the french-fry industry has fought back by introducing new 4 Brad Carlson, “Federal Lawsuit Alleges Potato Price-Fixing: Idaho Federal District Court Hears Round of Claims to Dismiss,” The Idaho Business Review (Online), June 20, 2011; Gregory E. Heltzer and Nicole Castle, “Potato Price-Fixing Case Survives Motion to Dismiss Holds That Pre-Production Agricultural Output Restrictions Are Not Exempt Under Capper-Volstead,” Antitrust Alert, December 8, 2011. 5 This discussion is based on Jill Carroll and Shirley Leung, “U.S. Consumption of French Fries Is Sliding As Diners Opt for Healthy,” Wall Street Journal, February 20, 2002. 201 M07_FARN0095_03_GE_C07.INDD 201 13/08/14 1:36 PM 202 PART 1 Microeconomic Analysis products, including blue, chocolate, and cinnamon-and-sugar french fries, there are still severe consequences for potato producers from the decreased fry consumption. Potato farmers and potato prices have also been affected by changes in consumers’ eating habits, including the popularity of the low-carbohydrate Atkins diet. It has been estimated that consumption of fresh potatoes per head is 40 percent below the level of 40 years ago because Americans do less cooking at home.6 In 2011, a Harvard nutrition study concluded that a four-year weight gain among the survey participants was most strongly associated with potato chips, followed by potatoes, sugared drinks, unprocessed red meats, and processed meats. Industry spokesmen indicated that this study might have an impact similar to that of the Atkins diet.7 There was also a controversy in 2011 when the U.S. Department of Agriculture (USDA) proposed to eliminate white potatoes from federally subsidized school breakfasts and to limit them sharply at lunch.8 In response, the National Potato Council urged the entire potato industry to mobilize. After intense lobbying, the U.S. Senate in the November 2011 agricultural funding bill added language blocking the USDA from limiting potatoes and gave the agency flexibility to regulate the preparation of potatoes in its final version of school nutrition guidelines. Members of the potato industry and their Congressional supporters were still concerned that the potato was being slighted compared with other vegetables. 8 6 “United States: Pass the Spuds: The Potato Industry,” The Economist 378 (March 25, 2006): 62. 7 Brad Carlson, “Idaho Potato Industry Hit by Harvard Nutrition Study,” The Idaho Business Review (Online), July 1, 2011. Jennifer Levitz and Betsy McKay, “Spuds, on the Verge of Being Expelled, Start a Food Fight in the Cafeteria,” Wall Street Journal (Online), May 17, 2011; Jen Lynds, “Lawmakers, Industry Decry ‘Backdoor Approach’ to Limiting Potatoes in Schools,” Bangor Daily News (Online), January 26, 2012. The Model of Perfect Competition The description of the potato industry in the chapter’s opening case shows that this industry closely approximates a perfectly competitive industry. The actual model of perfect competition is hypothetical. Although no industry meets all the characteristics described here, the industries discussed in this chapter come close on many of them. Characteristics of the Model of Perfect Competition Perfect competition A market structure characterized by a large number of firms in the market, an undifferentiated product, ease of entry into the market, and complete information available to all market participants. Price-taker A characteristic of a perfectly competitive market in which the firm cannot influence the price of its product, but can sell any amount of its output at the price established by the market. M07_FARN0095_03_GE_C07.INDD 202 As shown in Table 7.1, perfect competition is a market structure characterized by 1. 2. 3. 4. A large number of firms in the market An undifferentiated product Ease of entry into the market or no barriers to entry Complete information available to all market participants In perfect competition, we distinguish between the behavior of an individual firm and the outcomes for the entire market or industry. The opening case discussed both the production decisions of individual farmers and the outcomes for the entire potato industry. The model of perfect competition is characterized by having so many firms in the industry that no single firm has any influence on the price of the product. Farmers make their own independent planting decisions and take the price that is established in the market by the overall forces of demand and supply. Because each farmer’s individual output is small relative to the entire market, individual producers are price-takers who cannot influence the price of the product. In a perfectly competitive market, products are undifferentiated. This market characteristic means that consumers do not care about the identity of the specific supplier of the product they purchase. Their purchase decision is based on price. In the potato industry, this characteristic holds in the frenchfry market, where processors do not differentiate among the suppliers of potatoes except in terms of transportation costs. The case noted that this 13/08/14 1:36 PM CHAPTER 7 Market Structure: Perfect Competition TABLE 7.1 203 Market Structure PERFECT COMPETITION MONOPOLISTIC COMPETITION OLIGOPOLY MONOPOLY Number of firms competing with each other Large number Large number Small number Single firm Nature of the product Undifferentiated Differentiated Undifferentiated or differentiated Unique differentiated product with no close substitutes Entry into the market No barriers to entry Few barriers to entry Many barriers to entry Many barriers to entry, often including legal restrictions Availability of information to market participants Complete information available Relatively good information available Information likely to be protected by patents, copyrights, and trade secrets Information likely to be protected by patents, copyrights, and trade secrets Firm’s control over price None Some Some, but limited by interdependent behavior Substantial CHARACTERISTIC characteristic does not hold in the markets for restaurant baked potatoes and bagged potatoes, where the Idaho brand name carries a premium price. The third characteristic of the perfectly competitive model is that entry into the industry by other firms is costless or that there are no barriers to entry. This characteristic is reasonably accurate in the potato industry, as the number of producers has increased around the world to satisfy the demands of french-fry processing plants in different countries. The final characteristic of the perfectly competitive model is that complete information is available to all market participants. This means that all participants know which firms are earning the greatest profits and how they are doing so. Although this issue is not explicitly discussed in the opening case, it appears that information on the technology of growing potatoes is widespread and can be easily transferred around the world. Individual farmers typically have a good understanding of the costs of production and the relationship between prices and costs in the industry. Model of the Industry or Market and the Firm Let’s examine the impact of these characteristics in the model of the perfectly competitive industry or market in Figure 7.1a and the individual firm in Figure 7.1b. Figure 7.1a presents the model of demand and supply that we have introduced (Chapter 2). The industry or market demand curve is a downward sloping demand curve showing the relationship between price and quantity demanded by the consumers in the market, holding all other factors constant. The industry supply curve shows the relationship between the price of the good and the quantity producers are willing to supply, all else held constant. We now add a description of the individual firm in perfect competition to this model (see Figure 7.1b). Note first that the demand curve facing the individual firm is horizontal. The individual firm in perfect competition is a price-taker. It takes M07_FARN0095_03_GE_C07.INDD 203 13/08/14 1:36 PM 204 PART 1 Microeconomic Analysis FIGURE 7.1 $ P The Model of Perfect Competition The perfectly competitive firm takes the equilibrium price set by the market and maximizes profit by producing where price, which also equals marginal revenue, is equal to marginal cost. The level of profit earned depends on the relationship between price and average total cost. MC S ATC PE A B D = P = MR D 0 QE Q (a) The Perfectly Competitive Industry or Market. 0 Q1 Q* Q2 Q (b) The Perfectly Competitive Individual Firm. the price established in the market and must then decide what quantity of output to produce. Because the firm cannot affect the price of the product, it faces a perfectly or infinitely elastic demand curve for its product. Profit maximization The assumed goal of firms, which is to develop strategies to earn the largest amount of profit possible. This can be accomplished by focusing on revenues or costs or both factors. Determining the Profit-Maximizing Level of Output How much output will this individual firm want to produce? The answer to that question depends on the goal of the firm, which we assume is profit maximization, or earning the largest amount of profit possible. Our definition of profit is given in Equation 7.1. 7.1 p = TR − TC where p = profit TR = total revenue TC = total cost Profit-maximizing rule To maximize profits, a firm should produce the level of output where marginal revenue equals marginal cost. Profit is the difference between the total revenue the firm receives from selling its output and the total cost of producing that output. Because both total revenue and total cost vary with the level of output produced, profit also varies with output. Given the goal of profit maximization, the firm will find and produce that level of output at which profit is the maximum.9 To do so, the firm should follow the profit-maximizing rule, given in Equation 7.2. 7.2 Produce that level of output where MR = MC where MR = marginal revenue = ∆TR/∆Q MC = marginal cost = ∆TC/∆Q 9 Various organizations may pursue other goals. Niskanen (1971) proposed the goal of budget maximization for government bureaucracies. In this environment, managers receive rewards for the size of the bureaucracies they control, even if some employees are redundant. Newhouse (1970) and Weisbrod (1988) also proposed alternative goals for nonprofit organizations. Even profit-maximizing firms may not always choose the levels of inputs and output that maximize profits in the short run. There may also be the principal-agent problem where profit maximization might be the goal of a firm’s shareholders but not necessarily of the managers or agents they hire to run the firm. See William A. Niskanen, Bureaucracy and Representative Government (Chicago: Aldine-Atherton, 1971); Joseph Newhouse, “Toward a Theory of Nonprofit Institutions: An Economic Model of a Hospital,” American Economic Review 60 (March 1970): 64–74; Burton A. Weisbrod, The Nonprofit Economy (Cambridge, MA: Harvard University Press, 1988); and Paul Milgrom and John Roberts, Economics, Organization, and Management (Englewood Cliffs, NJ: Prentice-Hall, 1992). M07_FARN0095_03_GE_C07.INDD 204 13/08/14 1:37 PM CHAPTER 7 Market Structure: Perfect Competition Marginal revenue is the additional revenue earned by selling an additional unit of output, while marginal cost is the additional cost of producing an additional unit of output. If a firm produces the level of output at which marginal revenue equals marginal cost, it will earn a larger profit than by producing any other amount of output. Although we can derive this rule mathematically,10 Figure 7.1b presents an intuitive explanation for why output level Q*, where marginal revenue equals marginal cost, maximizes profit for the perfectly competitive firm. In Figure 7.1b, we have drawn a short-run marginal cost curve, which has a long upward sloping portion due to the law of diminishing returns in production. We have discussed the relationship between demand and marginal revenue for a firm facing a downward sloping demand curve (Chapter 3). The demand curve showing price was always greater than marginal revenue for all positive levels of output. However, the perfectly competitive firm faces a horizontal or perfectly elastic demand curve. In this case, and only in this case, the demand curve, which shows the price of the product, is also the firm’s marginal revenue curve. Price equals marginal revenue for the perfectly competitive firm because the firm cannot lower the price to sell more units of output, given that it cannot influence price in the market. If the price of the product is $20, the firm can sell the first unit of output at $20. The marginal revenue, or the additional revenue that the firm takes in from selling this first unit of output, is $20. The firm can then sell the next unit of output at $20, given the price-taking characteristic of perfect competition. Total revenue from selling two units of output is $40. The marginal revenue from selling the second unit of output is $40 – $20 or $20. Therefore, the marginal revenue the firm receives from selling the second unit is the same as that received from selling the first unit and is equal to the product price. This relationship holds for all units of output. An intuitive argument for why the firm’s profit-maximizing level of output (Q* in Figure 7.1b) occurs where marginal revenue equals marginal cost is that producing any other level of output will result in a smaller profit. To understand this argument, let’s examine output levels both larger and smaller than Q*. Consider output level Q2 in Figure 7.1b, where MR 6 MC. At this level of output, the additional revenue that the firm takes in is less than the additional cost of producing that unit. Thus, the firm could not be maximizing profits if it produced that unit of output. This same argument holds not only for output Q2, but also for all units of output greater than Q*. Now look at output Q1. At this level of output, MR 7 MC. The firm makes a profit by producing and selling this unit because the additional revenue it receives is greater than the additional cost of producing the unit. However, if the firm stopped producing at output Q1, it would forgo all the profit it could earn on the units of output between Q1 and Q*. Thus, stopping production at Q1 or at any unit of output to the left of Q* would not maximize the firm’s profits. Therefore, Q* has to be the profit-maximizing unit of output where the firm earns the greatest amount of profit possible.11 205 Marginal revenue for the perfectly competitive firm The marginal revenue curve for the perfectly competitive firm is horizontal because the firm can sell all units of output at the market price, given the assumption of a perfectly elastic demand curve. Price equals marginal revenue for the perfectly competitive firm. 10 Given TR(Q) and TC(Q), p = TR(Q) - TC(Q) dp/dQ = dTR/dQ - dTC/dQ = 0 dTR/dQ = dTC/dQ or MR = MC Differentiating the profit function with respect to output and setting the result equal to zero gives maximum profit, which occurs where marginal revenue equals marginal cost. 11 A graph of profit versus output would resemble a hill where profit starts low, increases and reaches a maximum, and then decreases. The equality of marginal revenue and marginal cost gives the level of output (Q* in Figure 7.1b) at which the top of the hill is located. One qualification is that the equality of marginal revenue and marginal cost must be achieved where marginal cost is upward sloping. Profit would be minimized if marginal revenue equaled marginal cost on the downward sloping portion of the marginal cost curve. In certain situations the profit-maximizing level of output may be the loss-minimizing level of output. If market conditions are so unfavorable that a firm is not able to earn a positive profit at any level of output, the level of output where marginal revenue equals marginal cost will be the level where the firm minimizes its losses. If it produced any other level of output, it would suffer greater losses. M07_FARN0095_03_GE_C07.INDD 205 13/08/14 1:37 PM 206 PART 1 Microeconomic Analysis Determining the Amount of Profit Earned The next question we examine is what amount of profit the firm in Figure 7.1b will earn if it produces output level Q*. Although producing where marginal revenue equals marginal cost tells us that the firm is maximizing its profits, this equality does not tell us the amount of profit earned. To know whether profits are positive, negative, or zero, we need to examine the relationship either between total revenue and total cost or between price and average total cost. This relationship is shown in Table 7.2. If you know total revenue and total cost at the current level of output, you can quickly calculate the amount of profit earned. If you have total revenue and total cost function graphs showing how these variables change with the level of output produced, you can find the profit-maximizing level of output, where there is the greatest distance between the two curves, and calculate the profit at that point.12 Table 7.2 shows an alternative method of calculating profit that will be very useful in our market models. We can substitute (P)(Q) for total revenue and (ATC)(Q) for total cost in Table 7.2. Rearranging terms gives the expression (P – ATC)(Q) for profit. Therefore, if we know, either numerically or graphically, the relationship between product price and the average total cost of production, we know whether profit is positive, negative, or zero. We can see that the firm in Figure 7.1b is earning zero profit because it is producing the level of output Q*, where the product price just equals the average total cost of production. Graphically, the product price is distance 0A and the product quantity is distance 0Q*, so total revenue (which equals price times quantity) is the area 0ABQ*. Average total cost is the distance Q*B (which equals 0A) and quantity is the distance 0Q*, so total cost (which equals average total cost times quantity) is also the area 0ABQ*. Therefore, total revenue equals total cost, and profits are zero. The Shutdown Point for the Perfectly Competitive Firm We show the zero profit point for the perfectly competitive firm again in Figure 7.2 as output level Q2, where price P2 equals average total cost. Suppose the price in the market falls to P1. The goal of profit maximization means that the firm will now produce output Q1 because that is the output level where the new price (P1), which is equivalent to marginal revenue (MR1), equals marginal cost. However, price P1 is below TABLE 7.2 Calculation of Profit p = TR - TC p = (P)(Q) - (ATC)(Q) p = (P - ATC)(Q) If P 7 ATC, p 7 0 If P 6 ATC, p 6 0 If P = ATC, p = 0 12 In mathematical terms, profit is maximized at the output level where the slope of the total revenue curve (marginal revenue) equals the slope of the total cost curve (marginal cost). This is the level of output where there is the greatest distance between the two curves. Examining the values of total revenue and total cost gives you the amount of profit at that output level. M07_FARN0095_03_GE_C07.INDD 206 13/08/14 1:37 PM CHAPTER 7 Market Structure: Perfect Competition $ ATC AVC P2 P1 P0 0 FIGURE 7.2 MC P3 Q 0 Q 1Q 2 Q3 The Supply Curve for the Perfectly Competitive Firm The perfectly competitive firm will shut down if the market price falls below average variable cost. The supply curve for the perfectly competitive firm is that portion of its marginal cost curve above minimum average variable cost. Q the average total cost at output level Q1. Although the firm is earning negative economic profits or suffering losses by producing output level Q1, it should continue to produce at this price because it is covering all of its variable costs (P1 7 AVC) and some of its fixed costs. Remember that fixed costs are shown as the vertical distance between AVC and ATC. The firm could not continue forever in this situation, as it needs to cover the costs of its fixed input at some point. However, it is rational in this case for managers of the firm to wait and see if the product price will increase. If the price should fall still further to P0 (= MR0) and the firm produces output Q0 (where MR0 = MC), the firm is just covering its average variable cost (P0 = AVC), but it is not covering any of its fixed costs. If the price falls below P0 and is expected to remain there, managers would be better off shutting the firm down. By shutting down, the firm would lose only its fixed costs. If it continued to operate at a price below P0, the firm would lose both its fixed costs and some of its variable costs, as price would be less than average variable cost. Thus, P0, the price that equals the firm’s minimum average variable cost, is the shutdown point for the perfectly competitive firm. We illustrate these relationships among prices, costs, and profits for a specific set of cost and revenue functions in Table 7.3, Columns 1–8, where the alternative methods for calculating profit are shown in Columns 9 and 10. Columns 4 and 5 show that the firm is always following the profit-maximizing rule because it is producing where marginal revenue equals marginal cost. For the perfectly competitive firm, marginal revenue also equals price. The zero-profit level of output for the firm is 10 units, where total revenue equals total cost ($1,200) or price equals average total cost ($120). At a price of $204, the firm produces 12 units of output and earns a positive profit of $928. If the price falls to $60, the firm produces 8 units of output and earns –$544 in profit. This price is less than average total cost ($128), but greater than average variable cost ($28). Thus, the firm is covering some of its fixed costs at this level of output. Total revenue of $480 exceeds total variable cost of $224 (TC – TFC), so that $256 is applied to the fixed costs. If the price falls to $24, the firm produces 6 units of output and suffers a loss of $800. This price is exactly equal to the minimum average variable cost, so the firm covers all of its variable costs, but loses the entire fixed cost of $800. If the price falls to $15 and the firm continues to produce, the best it could do would be to produce 5 units of output and suffer a loss of $850. Because this price is below the average variable cost, the firm would be better off shutting down and losing only the $800 of fixed costs. Thus, the actual level of output at a price of $15 would be zero, with a profit equal to –$800. M07_FARN0095_03_GE_C07.INDD 207 207 Shutdown point for the perfectly competitive firm The price, which equals a firm’s minimum average variable cost, below which it is more profitable for the perfectly competitive firm to shut down than to continue to produce. 13/08/14 1:37 PM 208 PART 1 Microeconomic Analysis TABLE 7.3 Numerical Example Illustrating the Perfectly Competitive Firm (Q measured in units; all costs, revenues, and profits measured in dollars) Q (1) AVC (2) 5 25 ATC (3) P = MR (5) MC (4) 185 15 15 TR = PQ (6) 75 TC (7) TFC (8) Π = TR – TC (9) Π = (P– ATC)Q (10) 925 800 75 - 925 = -850 (15 - 185)5 = -850 (Shutdown) (Shutdown) 6 24 157.33 24 24 144 944 800 144 - 944 = -800 (24 - 157.33)6 = -800 8 28 128 60 60 480 1,024 800 480 - 1,024 = -544 (60 - 128)8 = -544 10 40 120 120 120 1,200 1,200 800 1,200 - 1,200 = 0 (120 - 120)10 = 0 12 60 126.67 204 204 2,448 1,520 800 2,448 - 1,520 = 928 (204 - 126.67)12 = 928 Source: This example is based on the following cost functions derived and modified from Alpha C. Chiang, Fundamental Methods of Mathematical Economics, 3rd ed. (New York: McGraw-Hill, 1984). We have not analyzed specific mathematical cost functions in this text, but we have discussed general cost and revenue functions. Total fixed cost: TFC = 800 Total variable cost: TVC = Q3 - 12Q2 + 60Q Total cost: TC = TFC + TVC = 800 + Q3 - 12Q2 + 60Q Average fixed cost: AFC = 800/Q Average variable cost: AVC = Q2 - 12Q + 60 Average total cost: ATC = TC/Q = AFC + AVC = (800/Q) + Q2 - 12Q + 60 Marginal cost: MC = dTC/dQ = 3Q2 - 24Q + 60 Supply curve for the perfectly competitive firm The portion of a firm’s marginal cost curve that lies above the minimum average variable cost. Supply curve for the perfectly competitive industry The curve that shows the output produced by all perfectly competitive firms in the industry at different prices. Supply Curve for the Perfectly Competitive Firm Figure 7.2 shows that if the price determined in the market is P0, the firm will produce output level Q0 because that is the profit-maximizing level of output where P = MR = MC and P = AVC. If the price increases to P1, the firm will increase its output to Q1. Similarly, if the price is P2, the firm will produce output level Q2, and it will increase output to level Q3 if the price rises to P3. This procedure traces the supply curve for the perfectly competitive firm. This supply curve, which shows a one-to-one relationship between the product price and the quantity of output the firm is willing to supply, is that portion of the firm’s marginal cost curve above the minimum average variable cost. The firm will stop producing if the price falls below the average variable cost. This supply curve is upward sloping because the firm’s marginal costs are increasing as the firm reaches the capacity of its fixed inputs. Supply Curve for the Perfectly Competitive Industry In Figure 7.1a we drew the supply curve for the perfectly competitive industry as upward sloping. We can now see the rationale for the shape of this industry curve, given the shape of the firm’s supply curve. The industry supply curve shows the quantity of output produced by all firms in the perfectly competitive industry at different prices. Because individual firms produce more output at higher prices, the industry supply curve will also be upward sloping.13 The industry supply curve would typically be flatter than the firm’s supply curve because it reflects the output produced by all firms in the industry at each price. However, the slope of the industry supply curve could become steeper if the prices of any inputs in production increase as firms produce more output. If any inputs are in limited supply, firms might bid up their prices as they increase output. We typically assume that input prices are constant even with changes in production. Appendix 7.A discusses industry supply in more detail and presents several agricultural examples. 13 This is the short-run supply curve for the perfectly competitive industry, as it assumes that the number of firms in the industry is constant. M07_FARN0095_03_GE_C07.INDD 208 13/08/14 1:37 PM CHAPTER 7 Market Structure: Perfect Competition 209 The Short Run in Perfect Competition Figure 7.2 presents the possible short-run outcomes for a firm in a perfectly competitive industry. The short run is a period of time in which the existing firms in the industry cannot change their scale of operation because at least one input is fixed for each firm. Firms also cannot enter or exit the industry during the short run. The different prices facing the firm in Figure 7.2 are determined by the industry demand and supply curves (Figure 7.1a). Because the firm cannot influence these prices, it produces the profit-maximizing level of output (where P = MR = MC) and can earn positive, zero, or negative profit, depending on the relationship between the existing market price and the firm’s average total cost. At price P3, the firm earns positive profit; at price P2, zero profit; and at prices P1 and P0, negative profit. If the price falls below P0, the firm will consider shutting down. Long-Run Adjustment in Perfect Competition: Entry and Exit Both entry and exit by new and existing firms and changes in the scale of operation by all firms can occur in the long run. We analyze each of these factors in turn to illustrate the characteristics of the long-run equilibrium that occurs in perfect competition. Although we describe these two adjustments sequentially, they could also occur simultaneously. Returning to Figure 7.2, we now argue that the zero-profit point at output level Q2 and price P2 represents an equilibrium situation for the firm in perfect competition. This outcome results from the method that economists use (and managers should use) to define costs. As you have learned, costs in economics are defined from the perspective of opportunity cost, which includes both explicit and implicit costs (Chapter 5). The costs measured by the ATC curve in Figure 7.2 include both the explicit costs and any implicit costs of production. Suppose that investors have a choice between investing in this firm and buying a government security paying 8 percent. Managers of the firm would have to pay at least 8 percent to attract financial investors to the firm. This 8 percent rate of return is included in the average total cost curve in Figure 7.2.14 Thus, the firm in Figure 7.2 is earning a zero economic profit that includes a normal rate of return on the investment in the firm. Resources in this activity are doing as well as if they were invested elsewhere. Therefore, the zero economic profit point is an equilibrium point for the perfectly competitive firm. We illustrate this concept by showing what happens if an equilibrium situation is disturbed in Figures 7.3a and 7.3b. Suppose that some factor causes the industry $ P S1 S2 ATC D2 = P2 = MR2 PE1 A D2 B D1 = P1 = MR1 D1 0 Q E1 Q E2 Q E3 Q (a) Change in Demand in the Perfectly Competitive Industry or Market. 0 Q1 Q2 The point where price equals average total cost because the firm earns zero economic profit at this point. Economic profit incorporates all implicit costs of production, including a normal rate of return on the firm’s investment. FIGURE 7.3 MC PE2 Equilibrium point for the perfectly competitive firm Q (b) Change in Demand for the Perfectly Competitive Individual Firm. Long-Run Adjustment in Perfect Competition: Entry and Exit An increase in industry demand will result in a positive economic profit for a perfectly competitive firm. However, this profit will be competed away by the entry of other firms into the market in the long run. The zero economic profit point or the point where price equals average total cost is the equilibrium point for the perfectly competitive firm. 14 Former Coca-Cola CEO Robert Goizueta judged his managers in each operating division on the basis of their economic profit earned (Chapter 5). M07_FARN0095_03_GE_C07.INDD 209 13/08/14 1:37 PM 210 PART 1 Microeconomic Analysis demand curve to shift out from D1 to D2 in Figure 7.3a. This shift could result from a change in any of the factors held constant in demand curve D1, including consumer tastes and preferences, consumer income, and the price of goods related in consumption (substitutes and complements). This increase in demand causes the equilibrium price in the market to rise from PE1 to PE2 and the equilibrium quantity to increase from QE1 to QE2. How does the perfectly competitive firm respond to this change in the market? The firm’s reaction is shown in Figure 7.3b. Because the firm is a price-taker, it must accept the new equilibrium price and determine the level of output that maximizes profit at this new price. The firm faces a new horizontal demand curve, D2, where the new price, P2, equals the new marginal revenue, MR2. To maximize profits, the firm must produce where MR2 equals MC, or at output level Q2. However, at this level of output, the firm is now earning positive economic profits because the price of the product, P2, is greater than the average total cost of production at output Q2. Firms in this industry are now doing better than firms in other areas of the economy. Given this situation, firms in other sectors of the economy will enter this industry in pursuit of these positive economic profits. All firms know of the existence of these positive economic profits, given the characteristic of perfect information in the model of perfect competition. Other firms are able to enter the industry, given the characteristic of perfect mobility or no barriers to entry. Entry by new firms into the industry is shown by a rightward shift of the industry supply curve in Figure 7.3a from S1 to S2. As the supply curve shifts along demand curve D2, the equilibrium price begins to fall. Thus, the price, marginal revenue, and demand line D2 in Figure 7.3b start to shift down. The profit-maximizing level of output for the firm moves back toward Q1, and the level of positive economic profit decreases because the price of the product is closer to the average total cost of production. Entry continues until the industry supply curve has shifted to S2. At this point, the firm is once again producing Q1 level of output and earning zero economic profit (Figure 7.3b). Industry output is larger (QE3) because there are more firms in the industry (Figure 7.3a). However, because firms in the industry are once again earning zero economic profit, there is no incentive for further entry into the industry. Thus, the zero-economic-profit point is an equilibrium position for firms in a perfectly competitive industry.15 If, starting at the equilibrium position in Figure 7.3a, there was a decrease in industry demand, the return to equilibrium would occur, but in the opposite direction. The decrease in demand would result in a lower equilibrium price. A lower equilibrium price in the market would cause some firms to exit from the industry because they were earning negative economic profits or suffering losses. As firms exited the industry, the industry supply curve would shift to the left, driving the equilibrium price back up. This adjustment process would continue until all the losses had been competed away and firms in the industry were once again earning zero economic profit. Adjustment in the Potato Industry The process we have just described is illustrated for the potato industry in the opening discussion of this chapter. Figure 7.4a shows the demand and supply conditions for the potato industry in 1995 and 1996, while Figure 7.4b shows the 15 Figure 7.3 illustrates the case of a constant-cost industry where the entry of other firms does not affect the cost curves of firms in the industry. If entry increased the demand for inputs, which increased their prices and caused firms’ cost curves to shift up, the equality of price and average total cost would occur at a higher level of cost and this would be an increasing-cost industry. If the opposite should happen and costs were lower after entry, this would be a decreasing-cost industry. M07_FARN0095_03_GE_C07.INDD 210 13/08/14 1:37 PM CHAPTER 7 Market Structure: Perfect Competition P $ S95 MC A A $8.00 AVC S96 B $2.00 ATC B D 95 0 Q 95 Q 96 Q (100-lb. sack) (a) Potato Industry 0 Q2 Q1 Q (b) Individual Producer 211 FIGURE 7.4 Adjustment in the Potato Industry The original equilibrium at point A in Figures 7.4a and 7.4b shows the high price ($8.00 per 100-pound sack) and profits for potato farmers in 1995. In response to these profits, farmers planted more potatoes in 1996, shifting the supply curve from S95 to S96. This increase in supply drove the price down to $2.00 per 100-pound sack (point B), less than the average total cost for many producers, leaving farmers with heavy debts. profitability of individual farmers. The high price of $8.00 per 100-pound sack and the profits earned by individual farmers are shown at point A in both of the figures. In response to these prices and profits, farmers planted more potatoes in 1996, shifting the supply curve from S95 to S96. Favorable weather and insect conditions helped increase this supply, which drove the price of potatoes down to $2.00 per 100-pound sack (point B in Figure 7.4a). This price was below the average total cost for many farmers, leaving them with significant debts (point B in Figure 7.4b). Although not discussed, it is likely that many farmers produced fewer potatoes in 1997, shifting the supply curve to the left and driving price back up toward the zeroeconomic profit equilibrium, as the competitive model predicts. Further changes in the potato market would result from the subsequent decreased demand for french fries discussed in the case. Long-Run Adjustment in Perfect Competition: The Optimal Scale of Production We have just seen how entry and exit in a perfectly competitive industry result in the zero-economic profit equilibrium (P = ATC). That discussion focused on the role of entry and exit in response to positive or negative economic profits in achieving equilibrium. However, we illustrated the discussion in terms of a given scale of operation or a given set of short-run cost curves. Firms also must choose their optimal scale of operation. Let’s now look at how a competitive market forces managers to choose the most profitable scale of operation for the firm and how entry and exit again result in a zero-economic profit equilibrium. Figure 7.5 shows a U-shaped long-run average cost curve (LRAC). This curve incorporates both economies of scale (decreasing long-run average cost) and $ P1 = MR1 SMC2 SATC2 M07_FARN0095_03_GE_C07.INDD 211 Q1 Achieving lower unit costs of production by adopting a larger scale of production, represented by the downward sloping portion of a long-run average cost curve. FIGURE 7.5 SMC1 SATC1 0 Economies of scale Q2 LRAC P2 = MR2 Long-Run Adjustment in Perfect Competition: The Optimal Scale of Operation In the long run, the perfectly competitive firm has to choose the optimal scale of operation. This decision, combined with entry and exit, will force price to equal long-run average cost. Q 13/08/14 1:37 PM 212 PART 1 Microeconomic Analysis Diseconomies of scale Incurring higher unit costs of production by adopting a larger scale of production, represented by the upward sloping portion of a long-run average cost curve. diseconomies of scale (increasing long-run average cost) for the firm. Suppose that the perfectly competitive firm is originally producing at the scale of operation represented by the short-run marginal and average total cost curves SMC1 and SATC1. The firm is in equilibrium at price P1 because the firm is producing output Q1, where P1 = MR1 = MC and P1 = SATC1. In the short run, this represents the most profitable strategy for the firm, as the firm is locked into this scale of production. If managers of the firm know that the long-run average cost curve is as pictured in Figure 7.5, they can decrease their costs of production by moving to larger-scale production. Perfectly competitive firms cannot influence the price of the product, but they can find means of lowering production costs. Managers of the firm in Figure 7.5 should switch to the scale of production represented by the short-run marginal and average total cost curves SMC2 and SATC2. Price P1 is significantly above the short-run average total cost represented by SATC2, so that a firm of this size would earn positive economic profits. Positive economic profits, however, will attract other firms to the industry, and entry will shift the industry supply curve (not pictured in Figure 7.5) to the right, lowering price. These new firms entering the industry will also build plants at the SMC2 and SATC2 scale of operation, as that size represents the scale of operation that minimizes a firm’s costs. This process will continue until all economic profits have been competed away and price equals long-run average cost. Firms will produce at the scale of operation represented by SMC2 and SATC2 and will earn zero economic profit. This scale is at the minimum point of the long-run average cost curve, so that production costs are minimized. Figure 7.5 combines the two types of adjustments that are made to reach equilibrium (P = LRAC) in the long run: 1. The choice of the scale of operation that minimizes costs in the long run 2. Entry by firms, which lowers product price and competes away any positive economic profits Managerial Rule of Thumb Competition Means Little Control over Price Managers in highly or perfectly competitive markets have little or no control over the price of their product. They typically compete on the basis of lowering the costs of production. Perfectly competitive firms will end up earning zero economic profit because entry by other firms will rapidly compete away any excess profit. ■ Other Illustrations of Competitive Markets Most markets that people encounter on a day-to-day basis are not perfectly or even highly competitive because these markets do not meet the four characteristics discussed earlier in the chapter. We examine the agricultural sector in more detail to show how farming is one of the best examples of a perfectly competitive industry. Using the cases of broiler chickens, red meat, and milk, we then show how industries or sections of industries can become less competitive over time through mergers among producers and increased product differentiation. These factors represent violations of the first two characteristics in the competitive model: 1. A large number of price-taking firms in each industry 2. Production of an undifferentiated product M07_FARN0095_03_GE_C07.INDD 212 13/08/14 1:37 PM CHAPTER 7 Market Structure: Perfect Competition We then discuss how the trucking industry, although not perfectly competitive, illustrates many of the behaviors and outcomes of an extremely competitive industry. In this discussion, we introduce the concept of industry concentration, which is a measure of how many firms produce the total output of an industry. The more concentrated the industry, the fewer the firms operating in the industry. By definition, a perfectly competitive industry is so unconcentrated that individual firms are price-takers and do not have any market power. We will discuss different measures of industry concentration when we describe the strategies and behaviors of managers in firms with market power. 213 Industry concentration A measure of how many firms produce the total output of an industry. The more concentrated the industry, the fewer the firms operating in that industry. Competition and the Agricultural Industry Although the number of farms has decreased significantly over the past 70 years, there are still approximately 2 million farms in the United States today.16 The average farm contains less than 440 acres, but large-scale farms dominate much of the market due to economies of scale. While only 5 percent of all farms contain 1,000 acres or more, these farms cover more than 40 percent of total farm acreage. Today corporate farms operate 12 percent of all U.S. farmland and sell 22 percent of the total value of farm crops. Although farming has become an increasingly concentrated industry, the perfectly competitive model can still be used to characterize it. The largest 2 or 3 percent of the growers of any particular product are characterized by a large number of independent producers. For example, 2 percent of the largest farms grow half of all the grain in the United States. However, this 2 percent consists of 27,000 farms. In contrast, highly competitive manufacturing industries, such as men’s work clothing and cotton-weaving mills, have 300 and 200 firms, respectively. There are nearly 100 times as many independent producers in farming as in most competitive manufacturing industries. Demand for most farm crops is highly inelastic. People can only eat so much food, most commodities have few good substitutes, and these commodities constitute small shares of the total costs of the processed products to which they are converted. Products are typically grown and brought to market without individual farmers knowing exactly what price they will receive. If, as we discussed in the opening case of this chapter, farmers have responded to previous high prices and there are unusually good growing conditions, there may be large increases in supply, which drive down prices. A decrease in product price with inelastic demand results in a decrease in total revenue for producers because consumers do not increase quantity demanded in proportion to the price decrease. This outcome results in what has been called the “farm problem” in the United States and most industrialized countries. Prices for farm products are extremely volatile. For example, from 1970 to 2006 the mean annual corn price received by Iowa farmers was $2.23 per bushel, but prices ranged from a low of $1.04 to a high of $3.20. Because farm incomes are subject to extreme changes not under the control of farmers, governments have often implemented farm price support programs and other methods to control production. These programs have caused imbalances between supply and demand in otherwise competitive markets, as support prices are higher than the equilibrium prices in these markets. The lack of control over prices has also led farmers to organize cooperatives, as discussed in the opening case. 16 This discussion is based on Daniel B. Suits, “Agriculture,” in The Structure of American Industry, eds. Walter Adams and James W. Brock, 11th ed. (Upper Saddle River, NJ: Prentice Hall, 2005), 1–22; Bruce W. Marion and James M. MacDonald, “The Agriculture Industry,” in The Structure of American Industry, ed. James W. Brock, 12th ed. (Upper Saddle River, NJ: Prentice-Hall, 2009), 1–29. M07_FARN0095_03_GE_C07.INDD 213 13/08/14 1:37 PM 214 PART 1 Microeconomic Analysis Competition and the Broiler Chicken Industry Broiler chickens present an interesting example of an industry that traditionally was unconcentrated and produced a relatively undifferentiated product, but that has changed significantly over time.17 Broiler processing is a vertically integrated industry with the processors either owning or contracting each stage of the system from the breeder farms through the processing plants to the final products for market. Concentration in the broiler processing industry remained relatively low from 1954 until the mid-1970s. The four largest firms in the industry accounted for only 18 percent of the market over this period. Although this concentration increased throughout the 1980s, so that the four largest firms produced 40 percent of industry output by 1989, concentration in the broiler industry was still less than that found in other food manufacturing industries. Most of the increase in industry concentration during the 1980s resulted from mergers among the leading firms in the industry. Tyson Foods was the leading broiler processor, with a 22 percent market share, followed by Gold Kist and Perdue Farms, each with 8 percent, and ConAgra Poultry, with 6 percent. Many of the smaller broiler processors specialized in various regions of the country. Integration reduced costs by coordinating production at each stage to avoid overproduction and shortages and by achieving economies of scale to purchase feed, medicine, and equipment at lower prices. In the 1930s, there were approximately 11,000 independent facilities hatching broiler chicks, each with an average capacity of 24,000 eggs. By 2001, the number of hatcheries had declined by 97 percent to only 323, each with an average incubator capacity of 2.7 million eggs. Integration increased quality control and allowed firms to complete the entire production process in one localized area. This change had an important effect on costs, given the high rate of bird death and weight loss during transport. Integration also helped in the diffusion of new technology given that off-farm firms had greater access to capital and credit opportunities that could be used for new investments in genetic research and feed development.18 Both real and subjective product differentiation exists among the different broiler processors. Early differentiation focused on differences in product quality, product form, and the level of services provided to the retailer. In the 1970s, Holly Farms was the first processor to develop tray-packed chicken ready for the meat case. Processors today often apply the retailer’s own scanner pricing labels before shipment. Skin color became a differentiating characteristic, with Perdue Farms making its yellow color the first theme in its advertising campaign. This was followed by an emphasis on the fat content of the chickens. The amount of advertising in relation to product sales is a measure of product differentiation, as there is no need for individual suppliers to advertise an undifferentiated product in the perfectly competitive model. Broiler chicken advertising gained momentum with Frank Perdue of Perdue Farms, who was used in ads for his own product because he looked and sounded like a chicken. By 1990, the broiler industry was spending over $30 million on advertising, with Perdue Farms accounting for 41.6 percent of the total expenditure. Even with these increases, the advertising–sales ratio for broiler producers was just 0.2 percent in 1992 compared to an average for all food and tobacco industries of 2.0 percent.19 17 This discussion is based primarily on Richard T. Rogers, “Broilers: Differentiating a Commodity,” in Industry Studies, ed. Larry L. Duetsch, 2nd ed. (Armonk, NY: Sharpe, 1998), 65–100. 18 Elanor Starmer, Aimee Witteman, and Timothy Wise, “Feeding the Factory Farm: Implicit Subsidies to the Broiler Chicken Industry.” Medford, MA: Tufts University Global Development and Environmental Institute Working Paper No. 06-03, June 2006. 19 Food industries with the highest ratios in 1992 included chewing gum (16 percent), breakfast cereals (11 percent), chocolate candy (13 percent), and instant coffee (10 percent). See Rogers, “Broilers,” 79–88. M07_FARN0095_03_GE_C07.INDD 214 13/08/14 1:37 PM CHAPTER 7 Market Structure: Perfect Competition Competition among broiler processors depends on the marketing channel used and the extent of value-added processing involved. Food service and retail food stores are the two major marketing channels. Value-added processing ranges from unbranded fresh whole chickens to breaded nuggets and marinated prime parts. Firms tend to compete within these subcategories and to create barriers to entry in these submarkets. Other market niches are kosher chickens and free-range chickens, grown with fewer antibiotics and hormones. Consumer prices vary by these different subcategories. We noted above that, for competitive firms, price = marginal revenue = marginal cost for profit maximization and price = average total cost in equilibrium. Analysts often use the price-cost margin (PCM) from the Census of Manufactures as a proxy for these relationships. As would be expected for a competitive industry, broiler processing has one of the lowest PCMs in the food system. In 1992, the PCM for broilers was 11.9 percent compared with an average of 30 percent for all food and tobacco product classes. For more concentrated and differentiated food industries, the PCM ranged as high as 67.2 percent for breakfast cereals, 56.7 percent for chewing gum, and 49.6 percent for beer. In 2011, chicken farmers again confronted the issue of reducing supply, given increasing feed costs and weak demand.20 Yet it appeared that none of the large producers, including Sanderson Farms, Inc., Tyson Foods Inc., and Pilgrim’s Price Corp., wanted to be the first to cut back production. Eggs set in incubators, an indicator of future chicken supply, only started to level off. There were still expectations that consumers would switch from beef and pork to chicken, which gave companies an incentive to delay production cuts. Most uncertainty was related to the weather in the corn belt that would influence the price of corn used for chicken feed. However, as in the opening case on the potato industry, chicken producers’ behavior has also been subject to litigation.21 In October 2011, a federal judge ruled that Pilgrim’s Pride Corp. knowingly tried to manipulate chicken prices in 2009 and ordered the company to pay $26 million in damages to poultry growers in Arkansas. The judge concluded that a decision to close a chicken-processing plant in Arkansas was made to influence the price of chicken, and that the company violated the Packers and Stockyards Act of 1921, which prohibited livestock companies from unfair and deceptive practices. Thus, although the broiler processing industry exhibits many characteristics of a highly competitive industry, there are forces leading toward increased industry concentration and less-competitive behavior. This is to be expected, as most managers want to gain control over their market environment and insulate themselves from the overall supply and demand changes of a competitive market. 215 Price-cost margin (PCM) The relationship between price and costs for an industry, calculated by subtracting the total payroll and the cost of materials from the value of shipments and then dividing the results by the value of the shipments. The approach ignores taxes, corporate overhead, advertising and marketing, research, and interest expenses. Competition and the Red-Meat Industry Managers in the red-meat packing industry have recently followed the same strategies as those in the broiler chicken industry by introducing a campaign to turn what had been an undifferentiated product into one with brand names.22 Hormel Foods, IBP, and Farmland Industries, along with the meatpacking divisions of 20 Ian Berry, “Chicken Companies Wait in Vain for Industry Cutbacks,” Wall Street Journal (Online), May 20, 2011. 21 Marshall Eckblad, “Pilgrim’s Pride Manipulated Chicken Prices, Judge Rules,” Wall Street Journal (Online), October 4, 2011. 22 This discussion is based on Scott Kilman, “Meat Industry Launches Campaign to Turn Products into Brand Names,” Wall Street Journal, February 20, 2002. M07_FARN0095_03_GE_C07.INDD 215 13/08/14 1:37 PM 216 PART 1 Microeconomic Analysis Cargill and ConAgra Foods, now sell prepackaged meat, including steaks, chops, and roasts, under their brand names. According to the National Cattlemen’s Beef Association, 474 of these new beef products were introduced in 2001 compared with 70 in 1997. This is an important trend in an industry with $60 billion in annual sales. Branding represents a major shift in the red-meat industry, which traditionally labeled only its low-end products such as Spam. It also represents a strategy to combat the long-term decline in red-meat consumption in the United States, including the 41 percent decline in beef demand over the past 25 years. Much of this decline is related to health concerns regarding red-meat consumption. With both spouses working in many families, the time needed to cook roast beef is also a factor that has decreased beef demand. Managers in the red-meat industry were forced to develop and invest in new technology to produce roasts and chops that could be microwaved in less than 10 minutes. This involved cooking the beef at low temperatures for up to 12 hours and designing a plastic tough enough to hold the beef and its spices during this cooking process, consumer refrigeration, and microwaving. Managers also faced the problem of acceptance of this new product by both consumers and retail stores. Hormel targeted women in their twenties, who were the first generation to grow up with microwave ovens and who might have less reluctance than older women to put red meat in the microwave. All producers focused their marketing campaigns on the convenience of the new products, which they contend allow women to prepare a home-cooked meal for a family dinner while having time to relax. The goal of IBP’s marketing director, Jack Dunn, has been to “create an irrational loyalty to our product.”23 While many grocery stores welcomed the Hormel and IBP products, Kroger, the largest chain in the country, developed its own brand of fresh beef, the Cattleman’s Collection. Kroger managers followed the product differentiation strategy, but created a brand that consumers could not find elsewhere, which was more profitable for them than selling brands from other companies. All producers used coupons, product demonstrations, and extensive advertising budgets to promote the new products. These actions represent the behavior of managers in firms with market power (Chapter 8). Thus, the strategy of managers in competitive industries is to develop market power by creating brand identities for previously undifferentiated products. This process involves analyzing and changing consumer behavior and developing new technology and production processes. The red-meat industry has also developed other strategies to influence demand. In 2009, the National Cattlemen’s Beef Association launched the MBA (Masters of Beef Advocacy), a course that trained ranchers, feedlot operators, butchers, and chefs how to promote and defend red meat. MBA students listened to six online lectures on beef production and were assigned homework such as writing a probeef letter to a local newspaper. There was also in-person training on how to use social media to increase beef consumption.24 However, in 2012, there were two major issues that adversely affected the demand in the red-meat industry. The first was a report by the Harvard School of Medicine, which concluded that increased consumption of 3 ounces of red meat each day was associated with a 12 percent greater risk of premature death. Overall, that included a 16 percent greater risk of death due to heart disease and a 10 percent greater risk of death due to cancer. Increased risks from the consumption of processed 23 Ibid. Stephanie Simon, “Beef Industry Carves a Course: Cattlemen’s Group Promotes Red Meat, Trains Recruits to Win Over Consumers,” Wall Street Journal (Online), March 7, 2011. 24 M07_FARN0095_03_GE_C07.INDD 216 13/08/14 1:37 PM CHAPTER 7 Market Structure: Perfect Competition 217 meat, such as bacon, were even greater.25 The second was the controversy over the addition of “pink slime,” or lean finely textured beef to ground beef.26 Although this additive had been used for nearly two decades, a huge backlash developed on social media after celebrity chef Jamie Oliver detailed its production on a television show. Most major grocery chains announced they would phase out carrying ground beef that used the filler. Beef Products Inc., a major producer of the additive, closed three plants that made the lean finely textured beef. However, the red-meat industry fought back by arguing that eliminating the filler would result in more cows being slaughtered and in ground beef with more fat. The additive also received support from the U.S. Department of Agriculture and governors of five beef-producing states. Competition and the Milk Industry We have noted throughout this chapter that managers in competitive industries form industry or trade associations to promote the overall product, even if the identity of specific producers is not enhanced. This is a strategy to increase industry demand, as illustrated in Figure 7.3a. The milk industry has followed this strategy with its “Got milk?” and milk mustache campaigns.27 Milk consumption had been decreasing in the early 1990s before the initial “Got milk?” campaign was launched by Dairy Management Inc., representing dairy farmers, and the Milk Processor Education Program, sponsored by commercial milk producers. These organizations, with marketing budgets of $24 million in California and $180 million nationwide, are financed largely by industry members. A study by the California Milk Processor Board in early 2001 indicated that milk consumption in California had stabilized at the precampaign levels instead of continuing to decrease at 3 percent per year. Nationwide annual milk consumption also increased from 6.35 billion gallons to 6.48 billion gallons from 1995 to 2000. Although this campaign has increased the overall demand for milk, major national brands have yet to develop because milk production and pricing vary and are regulated by geographic region. The milk industry has also had to confront changes in lifestyles that work against it. Fewer people in all age groups are eating dry cereal with milk, and more are purchasing breakfast bars in the morning. In an attempt to stop the declining consumption in the teenage market, milk producers are developing single-serve packages and introducing an increasing variety of milk flavors. To enter Asian markets, New Zealand’s Fonterra, one of the world’s largest milk producers, has experimented with exotic flavors such as wheatgrass and the pandan leaf. Asia’s $35 billion overall dairy market has been expanding at a rate of 4 percent annually compared with a 2 percent annual increase in the United States. Fonterra also arranged for teaching hospitals in Hong Kong and Malaysia to conduct clinical trials to demonstrate the effect of milk on bone density, and it placed two dozen bone scanners in supermarkets across Asia to show consumers that their bones were not as dense as recommended by health experts.28 These moves represent the combined strategies of differentiating products and increasing overall demand in an industry that is still highly competitive. 25 Nicholas Bakalar, “Risks: More Red Meat, More Mortality,” The New York Times (Online), March 12, 2012. Ian Berry, “ ‘Pink Slime’ Fight Hurts Beef Demand, Tyson Says,” Wall Street Journal (Online), March 28, 2012; Bill Tomson and Mark Peters, “ ‘Pink Slime’ Defense Rises,” Wall Street Journal (Online), March 29, 2012; John Bussey, “Cows: The Innocent Bystanders,” Wall Street Journal (Online), April 5, 2012. 27 Bernard Stamler, “Got Sticking Power?” New York Times, July 30, 2001. 28 Cris Prystay, “Milk Industry’s Pitch in Asia: Try the Ginger or Rose Flavor,” Wall Street Journal, August 9, 2005. 26 M07_FARN0095_03_GE_C07.INDD 217 13/08/14 1:37 PM 218 PART 1 Microeconomic Analysis In 2004, the federal Dietary Guidelines Advisory Committee suggested that adults increase their milk consumption from two to three servings per day to “reduce the risk of low bone mass and contribute important amounts of many nutrients.” The dairy industry campaigned intensely for this change, launching a “3-A-Day” advertising campaign supported by companies such as Kraft Foods Inc. and warning of a “calcium crisis.” The National Dairy Council, funded by the country’s dairy farmers, spent $4 to $5 million in 2003 on research concluding that calcium and other nutrients in dairy products had significant health benefits.29 Political action is, therefore, another way to influence demand for a product. Milk producers associations continued with these strategies in 2011 and 2012. In November 2011, the National Milk Producers Federation proposed an overhaul of federal dairy policy that the Federation argued would save the government money and would prevent steep declines in the price of milk.30 The proposed program would force dairy farmers to cut production when milk prices fell toward unprofitable levels, a program similar to those that existed before the 1990s. Although the Federation argued that the program would reduce price volatility, many analysts estimated that consumer prices would rise substantially. The Milk Processor Education Program announced an updated version of the National Milk Mustache “got milk?” campaign in February 2012.31 The goal of this initiative, the Breakfast Project, was to promote milk drinking during breakfast and to use Salma Hayek, a bilingual spokesperson, in both English and Spanish advertisements. The project, aimed toward the Hispanic community, would use, “It’s not breakfast without milk,” as its tagline. Analysts estimated that the average American drank 21.3 gallons of milk in 2000 compared with 20.8 gallons in 2010. Competition and the Trucking Industry The trucking industry is another example of a highly, if not perfectly, competitive industry. There are more than 150,000 companies in the truckload segment of the industry, which delivers full trailer loads of freight.32 Most of these companies operate six or fewer trucks, and many are family-run businesses that make just enough money to cover truck payments and living costs. The large number of trucking firms, each with little market power, means that these firms exhibit the price-taking behavior and face the horizontal demand curve of firms in the model of perfect competition. As expected in a competitive industry, the changing forces of demand and supply can alter the profitability of trucking companies very quickly. In December 1999, trucking companies increased rates by 5 to 6 percent, given higher fuel prices and a shortage of truck drivers. Demand during this period was strong due to continued economic growth and greater reliance on trucking for freight transportation. However, the push from the cost side, combined with the limited ability to raise prices, meant that profits were still low for many trucking companies. By the fourth quarter of 2000, trucking companies faced not only continued higher costs, but also adverse weather and an overall slowing in the economy. 33 29 Nicholas Zamiska, “How Milk Got a Major Boost by Food Panel,” Wall Street Journal, August 30, 2004. Scott Kilman, “Dairy Farmers vs. Consumers,” Wall Street Journal (Online), November 25, 2011. 31 Tanzina Vega, “Two Languages, but a Single Focus on Milk at Meals,” The New York Times (Online), February 22, 2012. 32 Daniel Machalaba, “Trucking Firms Seek Rate Increase as Demand Rises, Fuel Costs Jump,” Wall Street Journal, December 9, 1999. 33 This section is based on the following articles: Sonoko Setaishi, “Truckers See Lackluster Results, Hurt by Higher Costs, Flat Rates,” Wall Street Journal, January 15, 2001; Sonoko Setaishi, “Truckers Face Dismal 1Q Amid Softer Demand, Higher Costs,” Wall Street Journal, April 5, 2001; Robert Johnson, “Small Trucking Firms Are Folding in Record Numbers Amid Slowdown,” Wall Street Journal, June 25, 2001. 30 M07_FARN0095_03_GE_C07.INDD 218 13/08/14 1:37 PM CHAPTER 7 Market Structure: Perfect Competition 219 Snowstorms in the Midwest forced many companies’ trucks to sit idle during the winter of 2000–2001. The slowing of consumer spending lowered sales of products that truckers haul. Business inventories began to increase, which made companies reluctant to ship more merchandise. Close to 4,000 trucking companies went out of business in 2000, and approximately 1,100 failed in the first quarter of 2001. As failed trucking companies left the industry, the remaining companies saw prices rise and became somewhat more profitable. Sale prices for used trucks decreased substantially due to the large number of trucking company bankruptcies. These bargains encouraged some truckers to reenter the business. Excess capacity continued to put downward competitive pressure on trucking rates, and rising costs for labor, fuel, and equipment continued to impact the trucking industry in 2006 and 2007. Increasing retirements among the nation’s drivers combined with the stressful nature of the job reduced the supply of drivers, causing wages to increase. Diesel fuel costs represent 25 percent of operating costs in the industry resulting in truckers spending $103 billion on 53 billion gallons of fuel in 2006. Demand for hauling services was negatively influenced by the defaults in the subprime mortgage markets. In response, some companies reduced the number of companyowned trucks in their fleets and shifted business to other freight services.34 The trucking industry was severely impacted by the economic downturn in 2008 and 2009. More than 3,000 firms with fewer than five power units went bankrupt in 2008. Refrigerated carriers suffered the least because they carried food, but flatbed carriers that relied on the housing industry and commercial construction were impacted the most. The reduced capacity from the recession could allow truckers to raise rates as the economy rebounded in 2010 and 2011. However, drivers’ wages, fuel costs, and high truck prices were likely to impact the recovery of the trucking industry.35 This discussion of the trucking industry illustrates the forces in the perfectly competitive model discussed in this chapter. Trucking firms have little power over price and are subject to the forces that change industry demand and supply. When demand declines and prices begin to decrease, some firms go out of business as price falls below their average variable costs. After firms exit the industry, prices begin to rise again, and the profitability of the remaining firms improves. Those firms still in the industry move back toward the zero-profit equilibrium point. Some individuals and companies may even see opportunities to earn greater than normal profits, which would cause new entry into the industry. Thus, there is a constant push toward the zero-economic profit equilibrium in a perfectly or highly competitive industry. Managerial Rule of Thumb Adopting Strategies to Gain Market Power in Competitive Industries Managers in highly competitive industries can gain market power by merging with other competitive firms, differentiating products that consumers previously considered to be undifferentiated commodities, and forming producer associations that attempt to change consumer preferences and increase demand for output of the entire industry. ■ 34 Ian Urbina, “Short on Drivers, Truckers Offer Perks,” New York Times, February 28, 2006; Daniel P. Bearth, “Trucking Faced Economic, Regulatory Challenges,” Transport Topics, December 24–31, 2007; Joan Garrett, “The Burden of Diesel Costs,” McClatchy-Tribune Business News, January 11, 2008. 35 Dave Willis, “Trucking—The Road to Recovery,” Rough Notes (Online), January, 2011; Jonathan Reiskin, “Trucking Is Doing Better Than U.S. Economy: Double-Dip Recession Unlikely, Experts Say,” Transport Topics, October 24, 2011. M07_FARN0095_03_GE_C07.INDD 219 13/08/14 1:37 PM 220 PART 1 Microeconomic Analysis Summary Perfect competition is a form of market structure in which individual firms have no control over product price, which is established by industry or market demand and supply. In the short run, perfectly competitive firms take the market price and produce the amount of output that maximizes their profits. Profits earned in the short run can be positive, zero, or negative. Perfectly competitive firms are not able to earn positive economic profits in the long run because these profits will be eroded by entry of other firms. Likewise, any losses will be removed by firms leaving the industry. To lower their costs, firms also seek to produce at the optimal scale of operation. However, this scale will be adopted by all firms in the long run, and entry will force prices to equal long-run average cost, the zero-economic profit equilibrium. Managers of firms in perfectly or highly competitive environments often attempt to gain market power by merging with other firms, differentiating their products, and forming associations to increase the demand for the overall industry output. We discuss these strategies in more detail when we examine firms with market power. Appendix 7A Industry Supply Elasticity of Supply The shape of the industry supply curve reflects the elasticity of supply within that industry. The elasticity of supply is a number showing the percentage change in the quantity of output supplied relative to the percentage change in product price. Because the quantity supplied usually increases with price, a supply elasticity is a positive number. As with demand elasticity, a supply elasticity number greater than 1 indicates elastic supply. The percentage change in quantity of output supplied is greater than the percentage change in price. Inelastic supply occurs when the percentage change in quantity supplied is less than the percentage change in price.36 A vertical supply curve represents perfectly inelastic supply, where there is a fixed quantity of the product supplied that is not influenced by the product price. In this case, the product price is determined entirely by changes in demand for the product as the demand curve moves up and down along a vertical supply curve. The best example of perfectly inelastic supply would be a painting, such as the Mona Lisa, by a deceased artist. There is only one of these paintings, and the supply will never be increased. The other polar case is perfectly elastic supply, illustrated by a horizontal supply curve. In this case, the industry is willing to supply any amount of product at the market price. Supply curves that are approaching being vertical are relatively more inelastic and show a smaller response of quantity supplied to changes in price, while flatter curves indicate a much larger (more elastic) supply response. 36 William G. Tomek and Kenneth L. Robinson, Agricultural Product Prices, 3rd ed. (Ithaca, NY: Cornell University Press, 1990), 59–75. M07_FARN0095_03_GE_C07.INDD 220 13/08/14 1:37 PM CHAPTER 7 Market Structure: Perfect Competition 221 Agricultural Supply Elasticities Supply curves for various agricultural products are illustrated by an S-shaped curve, as shown in Figure 7.A1.37 Changes in supply elasticity for a particular farm product are likely to occur at a price that just covers average variable costs or at a price at which the returns from alternative uses of resources are approximately equal. As we discussed earlier in the chapter, a price below the average variable cost means that a farmer will not offer any output for sale. At a price exceeding the average variable cost, supply may be elastic if more land is brought into production. Intermediate-level prices may cause supply elasticity to decrease if no additional land is available for cultivation or if equipment and labor are fully employed, whereas even higher prices may bring these resources into production and increase supply elasticity. Supply elasticities are typically lower for major crops grown in areas where there are few alternative uses of land, such as dry-land wheat, than for minor crops and poultry products. Supply elasticities can also differ by the stage of production. For broiler chickens, for example, the supply price response is greater for the breeding flock that supplies chicks for the broiler industry than for the production of broilers. The aggregate supply relationship for all farm output in most countries is very price inelastic in the short run. Resources committed to agriculture tend to remain in use, especially if alternative uses of these resources are limited. The land, labor, and equipment employed in agriculture often have few alternative uses elsewhere. And even with low product prices, farmers may produce other crops rather than seek employment off the farm. From 1929 to 1932, when farm prices fell by 50 percent, the aggregate amount of farm output remained relatively constant. The short-run price elasticity of aggregate farm output in the United States has been estimated to be no larger than 0.15. The increased specialization in farm equipment and skills has made short-run supply response even more difficult over time. For livestock products, supply changes are limited by the availability of the female stock and the time required to produce a new generation. Time periods up to eight years or more are required for a complete quantity adjustment to changing prices for some tree crops. Crop yields are influenced by the availability of irrigation water, the amount of fertilizer applied, and the pest control programs employed. Irrigation water is, in turn, influenced by pumping costs and water allotment rights. The weather, of course, also has a major influence on agricultural supply. If the weather is unusually wet, farmers may not be able to plant the desired acreage of their most profitable crop and may be forced to plant an alternative crop with a shorter growing season. FIGURE 7.A1 P Representative Supply Curve for a Farm Product The elasticity of supply for a farm product will vary with the price of the product. S 0 Q 37 The following discussion is based on Ibid., 59–61. M07_FARN0095_03_GE_C07.INDD 221 13/08/14 1:37 PM 222 PART 1 Microeconomic Analysis Key Terms supply curve for the perfectly competitive firm, p. 208 supply curve for the perfectly competitive industry, p. 208 perfect competition, p. 202 price-cost margin (PCM), p. 215 price-taker, p. 202 profit maximization, p. 204 profit-maximizing rule, p. 204 shutdown point for the perfectly competitive firm, p. 207 diseconomies of scale, p. 212 economies of scale, p. 211 equilibrium point for the perfectly competitive firm, p. 209 industry concentration, p. 213 marginal revenue for the perfectly competitive firm, p. 205 Exercises Technical Questions 1. For each of the following graphs, identify the firm’s profit-maximizing (or loss-minimizing) output. Is each firm making a profit? If not, should the firm continue to produce in the short run? P MC ATC P0 MR AVC Q P MC ATC P0 MR AVC Q P MC ATC 2. Consider a firm in a perfectly competitive industry. The firm has just built a plant that cost $15,000. Each unit of output requires $5 worth of materials. Each worker costs $3 per hour. a. Based on the information above, fill in the table on the following page. b. If the market price is $12.50, how many units of output will the firm produce? c. At that price, what is the firm’s profit or loss? Will the firm continue to produce in the short run? Carefully explain your answer. d. Graph your results. 3. Suppose Janet sells papayas at a perfectly competitive market in Thailand. While her average total cost (ATC) reaches a minimum level of $3, her minimum average variable cost (AVC) is $2. a. At what price will Janet reach the equilibrium point? Will Janet sell any papayas at that point? b. Under what circumstances will Janet’s shop shut down? 4. Consider the following graph, which shows a demand curve and two supply curves. Suppose that there is an increase in demand. Compare the equilibrium price and quantity change in both cases, and use those results to explain what you can infer about the elasticity of supply. AVC P0 MR S1 P S2 P0 Q D Q0 M07_FARN0095_03_GE_C07.INDD 222 Q 13/08/14 1:37 PM CHAPTER 7 Market Structure: Perfect Competition 5. Draw graphs showing a perfectly competitive firm and industry in long-run equilibrium. a. How do you know that the industry is in longrun equilibrium? b. Suppose that there is an increase in demand for this product. Show and explain the short-run adjustment process for both the firm and the industry. c. Show and explain the long-run adjustment process for both the firm and the industry. What will happen to the number of firms in the new long-run equilibrium? a. Why the only output that a competitive firm will produce in the long run is QE b. Why it will be a profit-maximizing decision to produce more than QE in the short run if the price exceeds PE $ LATC PE 6. The following graph shows the long-run average cost curve for a firm in a perfectly competitive industry. Draw a set of short-run cost curves consistent with output QE and use them to explain Number of Worker Hours Output (Q) 0 25 50 75 100 125 150 175 0 100 150 175 195 205 210 212 Total Fixed Cost (TFC) Total Variable Cost (TVC) 7. Suppose Kevin is operating a cake shop at a perfectly competitive market in South Korea and producing at the shutdown point. a. Draw graphs to show and explain the price and quantity of Kevin’s cakes, as well as his profit. 223 QE Total Cost (TC) Q Marginal Cost (MC) Average Variable Cost (AVC) Average Total Cost (ATC) — — — b. With the graphs drawn in response to question (a), show and explain the long-run adjustment process for Kevin’s cake shop and the cake industry. Application Questions 1. Discuss how the facts in the opening case study and the subsequent discussion of the potato industry illustrate the lack of control over prices by individual potato producers in a competitive market, the response to high prices predicted by the model of perfect competition, and the M07_FARN0095_03_GE_C07.INDD 223 attempts by producers in a competitive market to gain control over price. Check recent business publications to find out how successful the United Potato Growers of America cooperative has been since the time of this chapter’s case study. 13/08/14 1:37 PM 224 PART 1 Microeconomic Analysis 2. The following facts characterize the furniture industry in the United States:38 a. The industry has been very fragmented, so that few companies have the financial backing to make heavy investments in new technology and equipment. b. In 1998, only three U.S. furniture manufacturers had annual sales exceeding $1 billion. These firms accounted for only 20 percent of the market share, with the remainder split among 1,000 other manufacturers. c. Capital spending at one manufacturer, Furniture Brands, was only 2.2 percent of sales compared with 6.6 percent at Ford Motor Company. Outdated, labor-intensive production techniques were still being used by many firms. d. Furniture manufacturing involves a huge number of options to satisfy consumer preferences, but this extensive set of choices slows production and raises costs. e. Small competitors can enter the industry because large manufacturers have not built up any overwhelming advantage in efficiency. f. The American Furniture Manufacturers Association has prepared a public relations campaign to “encourage consumers to part with more of their disposable income on furniture.” g. In fall 2003, a group of 28 U.S. furniture manufacturers asked the U.S. government to impose antidumping trade duties on Chinese-made bedroom furniture, alleging unfair pricing. h. The globalization of the furniture industry since the 1980s has resulted from technological innovations, governmental implementation of economic development strategies and regulatory regimes that favor global investment and trade, and the emergence of furniture manufacturers and retailers with a capacity to develop global production and distribution networks. The development of global production networks using Chinese subcontractors has accelerated globalization in recent years. Discuss how these facts are consistent with the model of perfect competition. 3. Vietnam’s seafood exports in January and February 2014 increased 23.5 percent compared to 2013, and it is expected that the annual export target will be met with relative ease.39 Supposing Vietnam’s seafood market is perfectly competitive and originally at the long-run equilibrium, draw graphs to answer the following questions: a. What was the effect of the increase in exports on the market equilibrium price and quantity of seafood in Vietnam? b. What was the effect of the increase in exports on the profit of an individual fisherman? c. How will the number of fishermen in Vietnam change in the long run? How does it affect the seafood market? d. With the change in the number of fishermen, how will the profit of an individual fisherman change? e. With the change in profit in the long run, will individual fishermen exit the market? 4. Having won the bid for hosting the World Expo 2020, Dubai’s government allows landlords to raise their rents by 5 percent if they are originally 11 percent below the market rate determined by a rental index.40 What will be the effect of the increasing rents on a perfectly competitive firm’s profit-maximizing level of output and the amount of economic profit earned at that output? 38 James R. Hagerty and Robert Berner, “Ever Wondered Why Furniture Shopping Can Be Such a Pain?” Wall Street Journal, November 2, 1998; Dan Morse, “U.S. Furniture Makers Seek Tariffs on Chinese Imports,” Wall Street Journal, November 3, 2003; and Mark H. Drayse, “Globalization and Regional Change in the U.S. Furniture Industry,” Growth and Change 39 (June 2008): 252–82. 39 Ha Noi, “Seafood sees strong wave of exports,” Viet Nam News, March 7, 2014. 40 Michael Lahyani, “UAE housing market to go higher in 2014,” Khaleej Times (Online), December 29, 2013. M07_FARN0095_03_GE_C07.INDD 224 13/08/14 1:37 PM CHAPTER 7 Market Structure: Perfect Competition 5. In a perfectly competitive industry, the market price is $25. A firm is currently producing 10,000 units of output, its average total cost is $28, its marginal cost is $20, and its average variable cost is $20. Given these facts, explain whether the following statements are true or false: a. The firm is currently producing at the minimum average variable cost. M07_FARN0095_03_GE_C07.INDD 225 225 b. The firm should produce more output to maximize its profit. c. Average total cost will be less than $28 at the level of output that maximizes the firm’s profit. Hint: You should assume normal U-shaped cost curves for this problem. 13/08/14 1:37 PM 8 Market Structure: Monopoly and Monopolistic Competition I n this chapter, we contrast perfectly and highly competitive markets with the market structures of monopoly and monopolistic competition. These markets, along with oligopoly markets, are called imperfectly competitive markets or imperfect competition. We show how managers of firms in these markets have varying degrees of market power, or the ability to influence product prices and develop other competitive strategies that enable their firms to earn positive economic profits. The degree of a firm’s market power is related to the barriers to entry in a given market—the structural, legal, or regulatory characteristics of a firm and its market that keep other firms from producing the same or similar products at the same cost. We begin this chapter with the case of Eastman Kodak Co., and we describe how the changing markets for cameras and film eroded the once-substantial market power of this well-known company. After discussing the case, we present the monopoly model and illustrate the differences between this model and the perfectly competitive model. We then describe the major sources and measures of market power, illustrating the strategies that managers use to maintain and increase market power in several different industries. We also discuss basic antitrust policies that the federal government employs to control market power and promote competition, and we illustrate how market power tends to disappear in the monopolistically competitive market structure. 226 M08_FARN0095_03_GE_C08.INDD 226 13/08/14 1:35 PM Case for Analysis Changing Market Power for Eastman Kodak Co. Eastman Kodak Co., one of the most well-known and oncesuccessful companies in the United States, filed for bankruptcy in January 2012.1 This was a substantial change in direction for a company that once dominated its industry and had a near-monopoly on camera film, which earned it profits that it paid out to workers on “wage dividend days.” The company invented the digital camera in 1975, but then did not develop the new technology. In the film market, Kodak lost market share to foreign companies in the 1980s and stopped making investments in film in 2003.2 Discussion of a possible Kodak bankruptcy appeared in the media in fall 2011.3 After considering chemicals, bathroom cleaners, and medical testing devices in the 1980s and 1990s, the company struggled to rebuild its operations around commercial and consumer printing to offset the decline in film and photography gear sales. In August 2011, it began attempting to sell its portfolio of 1,100 digital patents to increase its cash position. Many potential buyers, however, were uncertain about buying patents from a company that might face bankruptcy. Kodak also sued companies such as Apple Inc. and HTC Corp. for patent infringement, alleging that these companies violated Kodak patents regarding the transmission of photos from mobile phones and tablets and image previewing by digital cameras. Kodak announced that it raised $3 billion between 2003 and 2010 from suits for patent infringement and licensing deals that settled these cases. However, the company alleged that Apple and HTC Corp. took advantage of its weakened financial condition to drag out litigation over the patent violations. A large burden of retiree benefits, the weak economy since 2008, and moves by vendors to cut relationships with the company also contributed to the bankruptcy filing. In early 2012 it was not clear whether the company would be able to emerge from bankruptcy in better financial condition and ready to survive in the consumer and commercial inkjet printing market dominated by rivals such as HewlettPackard Co. Kodak had to subsidize sales to build the market for its ink, and its workforce decreased from 64,000 in 2003 to 17,000 in 2011. In February 2012, the company announced that it would stop production of digital cameras, pocket video cameras, and digital picture frames, instead licensing its brand to other manufacturers.4 This strategy removed the company from the camera business, which it had pursued since George Eastman introduced the first Kodak camera in 1888. The company’s U.S. market share in digital cameras decreased from 16.6 percent in 2008 to 11.6 percent in 2011. The company had sustained the digital camera business because it helped win shelf space for its consumer inkjet printers. However, by early 2012 Kodak’s goal was to build its consumer business around online and retail-based photo kiosks, desktop inkjet printing, and camera accessories and batteries. 1 4 Mike Spector, Dana Mattioli, and Peg Brickley, “Can Bankruptcy Filing Save Kodak?” Wall Street Journal (Online), January 20, 2012. 2 Mike Spector and Dana Mattioli, “Kodak Teeters on the Brink,” Wall Street Journal (Online), January 5, 2012. 3 The following discussion is based on Dana Mattioli, “Squeeze Tightens on Kodak,” Wall Street Journal (Online), November 4, 2011; Dana Mattioli and Mike Spector, “Kodaks Rescue Plans Hit Hurdles,” Wall Street Journal (Online), December 19, 2011; and Dana Mattioli, “Kodak Sues Apple, HTC, and Realigns,” Wall Street Journal (Online), January 10, 2012. Dana Mattioli, “Kokak Shutters Camera Business,” Wall Street Journal (Online), February 10, 2012. 227 M08_FARN0095_03_GE_C08.INDD 227 13/08/14 1:35 PM 228 PART 1 Microeconomic Analysis Firms with Market Power Market power The ability of a firm to influence the prices of its products and develop other competitive strategies that enable it to earn large profits over longer periods of time. The opening case illustrates how one firm, Eastman Kodak Co., gained market power by developing the camera business for the general public and controlling the production of film, only to see this power eroded by failing to keep up with new technology and market changes. Firms attempt to gain market power through their pricing strategies, cost reduction, and new product development. However, this market power can decrease over time as market conditions fluctuate and the strategies of competitors evolve. We discuss numerous strategies that firms use to gain and preserve market power after we present the monopoly model and contrast it with the model of perfect competition. The Monopoly Model Monopoly A market structure characterized by a single firm producing a product with no close substitutes. Price-setter A firm in imperfect competition that faces a downward sloping demand curve and must set the profit-maximizing price to charge for its product. FIGURE 8.1A The Monopoly Model with Positive Economic Profit The monopolist maximizes profits by producing where marginal revenue equals marginal cost and typically earns positive economic profit due to barriers to entry. The industry or market demand curve in perfect competition is the standard downward sloping demand curve even though the perfectly competitive firm faces a horizontal demand curve. If we begin with our definition of a monopoly as a market structure characterized by a single firm producing a product with no close substitutes, we can see that a monopolist faces a downward sloping demand curve because the single firm produces the entire out...
Purchase answer to see full attachment
User generated content is uploaded by users for the purposes of learning and should be used following Studypool's honor code & terms of service.

Explanation & Answer

Attached.

Surname 1
Name
Tutor
Course
Date
Chapter 7: Technical Questions (page 23-24 in PDF)
Question 1
For each of the following graphs, identify the firm’s profit-maximizing (or loss-minimizing)
output. Is each firm making a profit? If not, should the firm continue to produce in the
short run?

Surname 2
In economics, the point of profit maximizing and loss minimizing is called MR=MC. This point
is where marginal revenue equals marginal cost, meaning that cost does not exceed revenue and
revenue does not exceed cost. This is a profit-maximizing zone, meaning that total cost is not the
lowest, but is farthest away from the total returns. The optimal point of production for the firm is
at the point MR=MC.
Profit maximization identifies the output level that has
a) the lowest average total cost of production
b) marginal revenue equal to marginal cost
c) a high price for its output
d) the biggest difference between marginal revenue and marginal cost
e) the biggest difference between average revenue and marginal cost
Firm 1 is making losses since the average total cost is higher than marginal revenue. However,
the firm can continue producing in the short run since it will achieve profits in the long run. Firm
2 is making profit since all cost curves are below the marginal cost curve. The firm should
continue producing in the short run. Firm 3 is making losses and should not continue producing
in the short run.

Question 2
Consider a firm in a perfectly competitive industry. The firm has just built a plant that cost
$15,000. Each unit of output requires $5 worth of materials. Each worker costs $3 per
hour.

a) Based on the information above, fill in the table on the following page

The table is shown below and have fully filled it.

Surname 3

Number
of
working
hours
0
25
50
75
100
125
150
175

Output
(Q)

Fixed
costs
(TFC)

Variable
Costs
(TVC)

Total
Costs
(TC)

Marginal
Cost
(MC)

0
100
150
175
195
205
210
212

15,000
15,000
15,000
15,000
15,000
15,000
15,000
15,000

0
575
900
1,100
1,275
1,400
1,500
1,585

15,000
15,575
15,900
16,100
16,275
16,400
16,500
16,585

5.75
6.50
8.00
8.75
12.50
20.00
42.50

Average
Variable
Cost
(AVC)
5.75
6.00
6.28
6.53
6.82
7.14
7.47

Average
Total
Cost
(ATC)
155.75
106.00
92.92
83.46
80.00
78.57
78.23

b) If the market price is $12.50, how many units of output will the firm produce?

In a perfectly competitive market the demand curve is perfectly elastic - in other
words demand and price stay the same for the product regardless of how much you sell therefore the amount you sell is determined by your ability to produce it and your costs in
doing so (you would stop producing at the point it ceased to be profitable – that is when
the marginal cost crosses the demand curve - but as the question does not specify a
change in costs with quantity produced it will never cross the demand curve - therefore
you produce until you reach the plant’s capacity).
Therefore, if the market price is $12.50 the firm will produce 205 units.

c) At that price, what is the firm’s profit or loss? Will the firm continue to produce in

the short run? Carefully explain your answer.
The firm’s profit is [(12.50) (205)] – 16,400 = 2,562.50 – 16,400
= –$13.837.50
The firm is losing money, but if it were to shut down, it would lose $15,000 (its fixed costs);
thus, the loss-minimizing choice is to stay in business in the short run (as P > AVC).

Surname 4
d) Graph your results.

The graph is shown below,

The Graph
20,000
15,000
10,000
5,000
0
1

2

3

4

5

6

Fixed costs (TFC) 15,000

Variable Costs (TVC) 0

Total Costs (TC) 15,000

Marginal Cost (MC) -

Average Variable Cost (AVC) -

Average Total Cost (ATC) -

7

Question 3
Suppose Janet sells papayas at a perfectly competitive market in Thailand. While her
average total cost (ATC) reaches a minimum level of $3, her minimum average variable
cost (AVC) is $2.
a) At what price will Janet reach the equilibrium point? Will Janet sell any papayas at

that point?
Janet will reach the equilibrium point when the price equals the minimum ATC, which is
$3. Although the economic profit is zero at that point, Janet will receive a normal rate of return
on the investment in her shop. Therefore, she will continue selling papayas.
b) Under what circumstances will Janet’s shop shut down?

When the price is below the minimum AVC, which is $2, it will be more profitable for
Janet to shut down her shop than to continue selling papayas.

Question 4
Consider the following graph, which shows a demand curve and two supply curves.
Suppose that there is an increase in demand. Compare the equilibrium price and quantity
change in both cases, and use those results to explain what you can infer about the elasticity
of supply.

Surname 5
Equilibrium price is the price where the demand for a product or a service is equal to the supply
of the product or service. At equilibrium, both consumers and producers are satisfied, thereby
keeping the price of the product or the service stable. Quantity change can be defined as a
movement along a given demand curve caused by a change in demand price.
From the graph, an increase in demand leads to a shift of the demand curve to the right. An
increase in demand leads to the supply curves shifting to the right. Due to this change, the
Equilibrium price will increase because of the increase in demand while the quantity will still
increase.
Price el...


Anonymous
Great! Studypool always delivers quality work.

Studypool
4.7
Trustpilot
4.5
Sitejabber
4.4

Similar Content

Related Tags