markets when firms are price takers

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Markets When Firms are Price Takers


Conditions for aMarket of Price Takers

• All firms produce an identical product.• A large number of firms are in the market.• Each firm supplies only a small portion of

the total supplied to the market.• No barriers to entry or exit exist.


Output

Price Firm

Output

Price Market

Price Taker’s Demand Curve• Market forces (supply & demand) determine price.• Price takers have no control over the price that they

may charge in the market. If such a firm was to charge a price above that established by the market, consumers would simply buy elsewhere.

• So, the price taker’s demand will be perfectly elastic. Only at the market price will there be any demand.

P

Marketdemand

Marketsupply

Firm’sdemand

P

Firms must take the market price


Output in the Short Run


MarginalRevenue =(MR) change in total revenue

change in output

Marginal Revenue• Marginal Revenue is the change in total

revenue divided by the change in output.

• In a price taker market, marginal revenue (MR) = market price, because all units are sold at the same price (market price).


• In the short run, the price taker will expand output until marginal revenue (MR = price) is just equal

to marginal cost (MC).

• When P > MC then the firm can make more on the next unit sold than it costs to increase output for that unit. In order for the firm to maximize its profits it increases output until MC = P.

• This will maximize the firm’s profits (rectangle PBAC).

d (P = MR)

q

Price

Output

ATC

MC

• When P < MC then the firm made

less on the last unit sold than it cost for that unit. In order for the

firm to maximize its profits it decreases output until MC = P.

Profit

AC

P B

increase q

P > MC

decrease q

P < MC

Profit Maximization when the Firm is a Price Taker

P = MC


Average and/ormarginal product

108642

25

50

100

12 14 16 18 20

Output

75

• At low levels of output TC > TR and, hence, profits are negative.

• An alternative way of viewing the firm’s profit maximization problem focuses on total revenue (TR) and total cost (TC).

TR

TCTotal

Revenue(TR) Output

TotalCost(TC)

Profit

(TR - TC) 0 2

8 10 12 14 15 16 18 20

010

4050

25.0033.75

48.0050.25

- 25.00- 23.75

6070758090

100

53.2559.2564.0070.0085.50

108.00

. . . . . .

- 8.00- 0.25 6.75 10.75 11.00

10.00 4.50 - 8.00

Total Revenue / Total Cost Approach

. . . . . .

Profits occur whereTR > TC

Losses occurwhere

TC > TR

Profits maximizedwhere difference

is largest

After some point, TR may exceed TC. Profits are largest where this difference is maximized.


MC

0 2

8 10 12 14 15 16 18 20

---- 5

5 5

----$ 3.95

$ 1.50$ 1.00

- 25.00- 23.75

1

3

7

9

5 5 5 5 5 5

5

$ 1.75$ 3.50$ 4.75$ 6.00$ 8.25

$ 13.00

- 8.00- .25 6.75 10.75 11.00

10.00 4.50 - 8.00

MR

. . . . . .

. . . . . .

MarginalRevenue

(MR) Output

MarginalCost(MC)

Profit

(TR - TC)Price and cost per Unit

108642 12 14 16 18 20

Output

Marginal Revenue / Marginal Cost Approach

• At low output levels MR > MC. • After some point, additional units cost more than the

MR realized from selling them.• Profit is maximized where P = MR = MC.

Profit Maximump = MR = MC


• The firm operates at an output level where P = MC, but here ATC > MC resulting in a loss.

• A firm experiencing losses but covering average variable costs will operate in the short-run.

• The magnitude of the firm’s short-run losses is equal to the size of the rectangle CABP1

d (P = MR)

q

ATCMC

ACP1

AVC

P2• A firm will shutdown in the short-run whenever price falls below average variable cost (P2).• A firm will shutdown in the long-run whenever price falls below average total cost.

Price

Output

Operating with Short-Run Losses

B

P = MC

Loss

P1


Output Adjustments in the Long Run


• The two conditions necessary for long-run equilibrium in a price-taker market are depicted here.

• Given the price established in the market, firms in the industry must earn zero economic profit (the “normal market rate of return”).

• The quantity supplied and the quantity demanded must be equal in the market, as shown below at P1 with output Q1.

Output

Price Firm

P1

q1

MC ATC

d1

Long-run Equilibrium

Output

Price Market

P1

D

Ssr

Q1


Output

Price

Output

Price

• Consider the market for toothpicks. A new candy that sticks to teeth causes the market demand for toothpicks to increase from D1 to D2 … market price increases to P2 …

MarketFirm

P1 P1

q1 Q1

D1

S1MC ATC

d1

Adjusting to Expansion in Demand

shifting the firm’s demand curve upward. At the higher price, firms expand output to q2 and earn short-run profits.• Economic profits will draw competitors into the industry, shifting the market supply curve from S1 to S2.

P2 d2

q2

D2

S2

Q2

P2


Output

Price

Output

Price

• After the increase in market supply, a new equilibrium is established at the original market price P1 and a larger rate of output (Q3).• As the market price returns to P1, the demand curve facing

the firm returns to its original level.• In the long-run, economic profits are driven down to zero.• Note the long-run market supply curve is flat (Slr).

Adjusting to Expansion in Demand

MarketFirm

P1 P1

q1 Q1

D1

S1MC ATC

d1

P2 d2

q2

D2

S2

Q2

P2

Slr

Q3

d1


The Case of Monopoly


Monopoly• Monopoly is a market with:

• high entry barriers, and,• a single seller of a well-defined product for

which there are no good substitutes.• Only a few markets exist with a single seller

but it is worth studying.• understanding monopoly theory also helps us

understand markets with only a few sellers.


Price and Output Under Monopoly• As there is only one producer of a good or

service in a market with a monopolist, the market demand curve is the monopolist’s demand curve.

• In order to maximize its profits, a monopolist will expand its output until marginal revenue just equals marginal cost.• The monopolist will charge the price along

the demand curve consistent with that level of output.


Price

Quantity/time

d

P

MR

q

MC

ATC

C B

A with price determined by the height of the demand curve at that level of output, P.

Price and Output Under Monopoly• The monopolist will reduce price and expand output as long

as MR > MC.

MR > MCMR < MC

• The monopolist will raise price and reduce output when ever MR < MC.• Output level q will result …

• At q the average total cost per unit for that scale of output is C.• As P > C (price > ATC) the firm is making economic profits equal to the area PABC.

Economicprofits


0 ----

Totalrevenue

= (1)*(2) (3)

Price(per unit)

(2)

Output(per day)

(1)

1 $25.00 2 3 4 5 6 7 8 9

10

----- $50.00

Totalcosts

(per day) (4)

Profit

= (3) - (4) (5)

Marginal

cost(6)

Marginalrevenue

(7)

$24.00$23.00$22.00$21.00$19.75$18.50$17.25$16.00$14.75

$25.00$48.00$69.00$88.00

$105.00$118.50$129.50$138.00$144.00$147.50

$60.00$69.00$77.00$84.00$90.50$96.75

$102.75$108.50$114.75$121.25

-$35.00-$21.00

-$8.00$4.00

$14.50$21.75$26.75$29.50$29.25$26.25

-$50.00 ----$10.00 $25.00

$9.00 $23.00$8.00 $21.00$7.00 $19.00$6.50 $17.00$6.25 $13.50$6.00 $11.00$5.75 $8.50$6.25 $6.00$6.50 $3.50

----

<<<<<<<<

Maximumprofits

• A monopolist will reduce price and expand output as long as MR > MC.

Price and Output Under Monopoly

• As the monopolist reduces price and expands output, profits increase … until the point where MC > MR.

• Here an output of 8 a day will maximize profits.


Profits Under Monopoly• High entry barriers protect monopolists from

competitive pressures.• Monopolists can earn long-run profits.

• However even a monopolist will not always be able to earn profit.• When ATC is always above the demand

curve, the monopolist will be unable to cover costs (unable to earn a profit).


• A monopolist will set output equal to q, where MR = MC

When a Monopolist Incurs Losses

d

P

MR

q

MC

ATCC A

B

Price

Quantity/time

Short-runlosses

• Note that at this level of output, the price that the monopolist charges does not cover the average total cost of producing the output ( P < C ).• Whenever the ATC curve lies always above the demand curve, the monopolist will incur short-run losses.• In this diagram the firm is making economic losses equal to the shaded area, CABP.


Characteristics of Oligopoly


Characteristics of Oligopoly• A few characteristics of oligopoly:

• small number of rival firms• interdependence among firms• substantial economies of scale• significant barriers to entry• products may be identical or differentiated


Price and Outputin the Case of Oligopoly


Price and Output Under Oligopoly• No general theory exists for price and output

under oligopoly.• If the firms operated independently, they

would drive down the price to the per unit cost of production.

• If the firms colluded perfectly, the price would rise to the monopoly price.

• The outcome is usually between these two extremes.


Price

DMR

PM

QC

PC

QM

LRATC

Price and Output Under Oligopoly• If oligopolists compete with one another, price cutting drives

price down to PC, and expands total output to QC .• In contrast, perfect cooperation among firms leads to a higher

price PM and a smaller market output of QM. • Due to the difficulty to perfectly collude, when firms try to

coordinate their activity, price is typically between PC and PM and output between QM and QC.

Quantity/time

Profits to oligopolywith perfect collusion.


Incentive to Collude• Oligopolists have a strong incentive to

collude and raise their prices. • However, each firm has an incentive to cheat

by lowering price because the demand curve facing each firm is more elastic than the market demand curve.

• This conflict makes collusive agreements difficult to maintain.


Price

Quantity/time

PriceIndustry Firm

DiMRi

Pf

qf

Pi

Qi

MC

dfMRf

MC

Pi

Gaining from Cheating• Using industry demand Di and marginal revenue MRi,

oligopolists maximize their joint profit where MRi = MC – at output Qi and price Pi .

• Demand facing each firm df (where no other firms cheat) would be much more elastic than industry demand Di .

• The firm maximizes its profit where MRf = MC by expanding output to qf and lowering its price to Pf from Pi .

Individual firms havean incentive to cheat by cutting price to

expand output

Quantity/time


Obstacles to Collusion• As the number of firms in an oligopolistic

market increases, the likelihood of effective collusion declines.

• When it is difficult to detect cheating (secret price cuts), effective collusion is less likely.

• Low entry barriers also make effective collusion less likely because profit attracts additional rivals.

• Unstable demand conditions lead to honest differences among firms about the size of shares and price that maximizes total profit.

• Rigorous enforcement of antitrust law makes collusion potentially more costly.


D

P0

MRQ0

LRATCMC

P1

P2

Q1 Q2

Regulation of a MonopolistPrice

Quantity/time

• An unregulated monopolist with the cost structure here produces where MR = MC (Q0) and charge price P0.• From an efficiency viewpoint, this output is too small and the price is too high. Why is this?

• If a regulatory agency forced the monopolist to reduce its price to P1 (average cost pricing) the monopolist expands output to Q1.• Ideally, we would like output to be expanded to Q2 where P = MC (marginal cost pricing), but regulatory bodies do not usually attempt to keep prices as low as P2. Can you explain why?

Average costpricing

Marginal costpricing


Problems with Government Intervention

• Problems with price regulation:• Lack of information – do regulators know the

cost structures behind the firm’s real ATC?• Cost shifting – with P = ATC, do monopolists

have much incentive to keep costs low?• Special interest influence – will monopolists

have an incentive to influence the decisions of regulatory bodies?

• Problem with government production:• Less incentive to minimize costs and adopt

new technologies.• Fewer incentives to satisfy customers,

improve quality, and introduce new products.• Political considerations may influence

decision making of firm.


Monopolistic Competition

Competitive Price-Searcher Markets


Competitive Price-Searcher Markets• Firms in price-searcher markets with low

entry barriers face a downward sloping demand curve. • Firms are free to set price, but face strong

competitive pressure.• Competition exists from existing firms and

potential rivals• An alternative term for such markets is

monopolistic competition.


Product Differentiation• Price-searchers produce differentiated

products – products that differ in design, dependability, location, ease of purchase, etc.• Rival firms produce similar products (good

substitutes) and therefore each firm confronts a highly elastic demand curve.


Price and Output• A profit-maximizing price searcher will

expand output as long as marginal revenue exceeds marginal cost.• Price will be lowered and output expanded

until MR = MC• The price charged by a price searcher will be

greater than its marginal cost.


Price

d

MR

MC

ATC

Price and Output: Short Run Profit

Quantity/timeq

P

C

EconomicProfits

• A price searcher maximizes profits by producing where MR = MC, at output level q … and charges a price P along the demand curve for that output level.

• At q the average total cost is C.• Because the price is greater than the

average total cost per unit (P > C) the firm is making economic profits equal to the area ( [ P - C ] * q ) • What impact will economic profits have if this is a typical firm?


Profits and Losses in the Long Run• If firms are making economic profits, then

rival firms will be attracted to the market.• The entry of new firms will expand supply

and lower price.• The demand curve of each will shift inward

until the economic profits are eliminated.• Economic losses will cause price searchers

to exit from the market.• Demand for the remaining firms’ output will

rise until the losses have been eliminated, ending the incentive to exit.

• Competitive price searchers can make either profits or losses in the short run, but only zero economic profit in the long run.


Price• Because entry and exit are free, competition will eventually drive prices down to the level of ATC.

Quantity/timeq

P

d

MR

MC

ATC

Price and Output: Long Run

• When profits (losses) are present, the demand curve will shift inward (outward) until the zero profit equilibrium is restored.• The price searcher establishes its output level where MC = MR.• At q the average total cost is equal to the market price. Zero economic profit is present. No incentive for firms to either enter or exit the market is present.

C = P


Price

Quantity/Time

Price Taker Price SearcherPrice

Quantity/Time

d

MC

ATC

dMR

MC

ATC

P2

q2

P1

q1

• Below, we show the long-run equilibrium for both price taker & price searcher markets with low entry barriers. For both, P = ATC and there are no economic profits.

• As the price-searcher faces a downward-sloping demand curve, its profit-maximizing price exceeds MC. In contrast with the price-taker market, price-searcher output is too small to minimize ATC in long-run equilibrium.

Comparing Price Searchers & Takers


Price

Quantity/Time

Price Taker Price SearcherPrice

Quantity/Time

d

Price MC

ATC

d

MC

ATC

P2

P1

Price

Comparing Price Searchers & Takers

MRq2q1

• Even though the two markets have the same cost structure, the price in the price-searcher’s market is higher than that in the price-taker’s market ( P2 > P1 ).

• Some consider this price discrepancy a sign of inefficiency; others perceive it as a premium society pays for variety and convenience (product differentiation).


Allocative Efficiency• Allocative efficiency is achieved when the

most desired goods are produced at the lowest possible cost.

• Criticism of traditional theory of competitive price-searcher markets:• price > marginal cost at the profit

maximizing output level• per-unit cost may not be minimized• excessive advertising is encouraged


Allocative Efficiency• Recently economists have been more positive

about competitive price-searcher markets.• Consumers may value a wider variety of

styles and quality (product differentiation).• Advertising often reduces search time and

provides valuable information.• Price searchers have an incentive to innovate

and operate efficiently.


A Special Case:Price Discrimination


Price Discrimination• Price discrimination:

When a seller charges different consumers different prices for the same good or service.

• Price discrimination can only occur when a price searcher is able to:• identify groups of customers with different

elasticities of demand• prevent customers re-trading the product.


Price Discrimination• Sellers may gain from price discrimination

by charging:• higher prices to groups of customers with

more inelastic demand • lower prices to groups of customers with

more elastic demand• Price discrimination generally leads to more

output and additional gains from trade.


The Economics of Price Discrimination

• If the airline charges all customers the same price, profits will be maximized where MC = MR. Here the airline charges everyone $400 and sells 100 seats.

Price

Quantity/timeSingle price

$400

$200

$300

$100

$500

$600

$700

MC

D100

MR

Net operating revenue($300*100) = $30,000

• Consider a hypothetical market for airline travel where the Marginal Cost per traveler is $100.

• This generates Net Operating Revenue of $30,000 or (total revenues) $40,000 – (operating costs) $10,000.


Price

Quantity/timeSingle price

$400

$200

$300

$100

$500

$600

$700

MC

D100

MR

Net operating revenue($300*100) = $30,000

The Economics of Price Discrimination• By charging higher prices to consumers with less

elastic demand and lower prices to those with more elastic demand it will increase net operating revenue.

• If the airline charges $600 to business travelers (who have a highly inelastic demand) and $300 to other travelers (who have a more elastic demand), it can increase its Net Operating Revenue to $42,000.

Price

Quantity/timePrice Discrim.

$400

$200

$300

$100

$500

$600

$700

MC

D

Net operating revenuefrom business travelers($500*60) = $30,000

Net operating revenuefrom all others

($200*60) = $12,000

60 120


Questions for Thought:1. Is price discrimination harmful to the

economy? How does price discrimination affect the total amount of gains from exchange? Explain. Why do colleges often charge students different prices, based on their family income?

2. What is the primary requirement for a market to be competitive? Is competition necessary for markets to work well? How does competition influence the following: (a) the cost efficiency of producers (b) the quality of products (c) new product discovery and development


Questions for Thought:3. Which of the following is a necessary

condition for long run equilibrium in both competitive price searcher and competitive price taker markets? a. Price must equal marginal cost (MC).b. The typical firm in the market must be

earning zero economic profit.c. All of the firms in the market must be

charging the same price.

4. “If a movie theater is going to increase its revenues by charging students a lower price than other customers, the demand of students must be more elastic than the demand of other customers.” Is this statement true?


Questions for Thought:5. Which of the following indicates that a firm

operating in the highly competitive retail sector is providing goods and services that consumers value highly relative to their cost? a. The firm is making losses and its sales

are declining. b. The wages earned by the employees of the

firm are low.c. The firm is highly profitable and its sales

have grown rapidly.

markets when firms are price takers

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