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.
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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.
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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.
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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
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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
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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).
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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.
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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.
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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.
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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.
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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).
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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.
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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
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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
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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.
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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.
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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.
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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
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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
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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
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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
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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
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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...
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