Chapter 6: The Theory and Estimation of Production
Equipped with the theories of production, cost and profit maximization for a single firm, we can investigate how competitive market conditions within an entire industry influence a firm’s prices, output and profitability.
In Chapter 10, we examine two important industry-level market structures:
Pure (“Perfect”) Competition
Monopolistic Competition
In addition, we explore McGuigan’s framework for Competitive Strategic Analysis.
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Chapter 10 - Prices, Output and Strategy:
Pure and Monopolistic Competition
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Chapter 10: Fundamental Concepts and Terminology
Relevant Market – The collection of individual firms who produce and sell competing products to consumers within an entire industry. These firms interact with each other in buyer-seller relationships.
Market Structure – The product, price and competitive inter-relationships between individual firms in a relevant market.
Four major elements of market structure are:
The number and relative size of firms in the industry.
The similarity of firms’ competing products sold within the industry; this is known as the degree of product differentiation.
The extent to which the decision-making of individual firms is independent, and not interdependent or collusive.
The conditions (ease or difficulty) for new firms to join an industry (“entry conditions”), or for established firms to leave an industry (“exit conditions”).
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Chapter 10: Fundamental Concepts and Terminology
Variability in Market Structure
Fragmented Market – A relevant market where there are a large number of relatively small firms. The four largest firms in a fragmented industry will constitute less than 10% of the sales for the entire relevant market.
Concentrated Market – The combined total sales of the four largest firms in the industry constitute a majority of the sales for an entire relevant market.
Consolidated Market – Through mergers, acquisitions and/or buyouts, a fragmented market evolves to become a more concentrated market (fewer firms, each relatively larger in size).
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Chapter 10: Fundamental Concepts and Terminology
Continuum of Market Structures – Economists identify four primary competitive market structures:
Pure (Perfect) Competition
Monopolistic Competition
Oligopoly
Monopoly
Levels of Economic Profit and Relevant Market Effects
Recall definition of Economic Profit:
Total Economic = Total ─ Total Explicit ─ Total Implicit
Profit (TEP XXXXXXXXXXRevenue XXXXXXXXXXCost XXXXXXXXXXCost
Normal, Above-Normal and Below-Normal Total Economic Profit
If TEP = 0, then TEP is normal. TEP covers opportunity cost.
If TEP > 0, then TEP is above-normal. Firms enter industry, if they can.
If TEP < 0, then TEP is below-normal. Firms exit industry, if they can.
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Next Steps for Exploring Key Ideas about Market Competition in Chapter 10:
First, fully develop these two models of relatively fragmented market structures:
Pure Competition
Monopolistic Competition
Then, expand on the important aspects of competitive strategy highlighted by McGuigan, et al.
What is the market model of Pure Competition?
Pure Competition is sometimes known as the theory of Perfect Competition because the model predicts market behavior under an idealized set of market conditions.
Pure Competition is an internally consistent market model. The theory relies on deductive logic to predict market results.
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Why study the purely-competitive model of a market?
No real-world market is purely competitive.
Nevertheless, an in-depth study of pure competition offers insights into the key market conditions that influence a firm’s decisions and outcomes for product output, pricing and profitability.
To properly understand the purely competitive model of a market, we must clearly delineate the ideal conditions governing this market model.
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The ideal market conditions governing Pure Competition are:
The market structure is perfectly fragmented. Many, many relatively-small firms sell products to many, many relatively small customers.
All firms produce a homogeneous (identical or non-differentiated) product.
Individual firms have perfect free-entry or free-exit to-and-from the industry. Levels of total-profit (or total-loss) are the primary motive for firms to enter or exit the industry.
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The ideal market conditions for Pure Competition are (continued):
Industry-wide supply and market demand levels determine an equili
ium product price per-unit-output faced by individual firms. Each firm is a “price-taker”. No single firm has any market power to control the industry’s product price.
Each firm in pure competition is very small compared to the industry-wide relevant consumer market. As a result, the owner-manager faces a firm-level horizontal straight-line demand function (with a zero-slope).
Individual producers can sell as many additional output units as are profitable, and they do not have to reduce price to sell more output units.
The situation is comparable to a farm grain-producer agreeing to sell additional bushels of product at a known and constant “going” market price level.
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The ideal market conditions for Pure Competition are (continued):
Relevant information for product pricing, cost of production and profitability is freely available to all interested market participants.
There are no secrets. Market information is public and not proprietary.
It is simple and costless to determine the profit levels (normal, above-normal or below-normal) of the firms operating in purely competitive markets.
All owner-managers of perfectly competitive firms are maximizers of Total Profit (TP).
To max TP, each manager independently decides to produce a total output level Q where the per-unit Product Price (P) equals the Marginal Cost (MC) of producing another output unit.
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During our examination of Cost Analysis in Chapter 8 [See Cost Analysis – Part 2 PowerPoint file], we graphically displayed the connection between the price determined by industry-wide supply and demand, and the product price faced by a purely competitive firm within the industry.
We review this relationship again below:
$Price per unit of Output
$Price per unit of Output
Quantity of Output (Q) [100’s of Q]
Quantity of Output (Q) [Million’s of Q]
Entire Purely Competitive Industry
One Small Purely
Competitive Firm
in the Industry
Industry Supply
Industry Demand
Firm’s Product Price = $Marginal Revenue
Equilib. $Price
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In Pure Competition, we can illustrate the scenario where an individual firm temporarily earns an above-normal level of Total Profit (TP). In this scenario:
Firm produces Q* where P = MC to maximize TP
At Q*, Product Price (P) > Average Total Cost (ATC)
When P > ATC, then TP > $0, and we say that TP is “above normal”.
$Price per unit of Output
or $MC
Or $ATC
Q* for Total Profit Max
$Marginal Cost ($MC)
$Marginal Revenue = $Product Price
XXXXXXXXXXMR) = ($P)
Maximize $Total Profit where
$Price = $Marginal Cost
$Average Total Cost ($ATC)
Quantity of Output (Q)
$Product Price ($P)
Maximum Total Profit (Since TP > 0, then it is above-normal)
$Average Total Cost ($ATC)
Total Cost =
$ATC • Q*
Total Revenue =
$P • Q*
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In Pure Competition, we can illustrate the scenario where an individual firm temporarily earns a below-normal (negative) level of Total Profit (TP). The firm is taking a loss. In this scenario:
Firm produces Q* where P = MC to minimize the total loss
At Q*, Product Price (P) < Average Total Cost (ATC)
When P < ATC, then TP < $0, and we say that TP is “below normal”.
$Price per unit of Output
or $MC
Or $ATC
Q* for Total Loss Minimizing
$Marginal Cost ($MC)
$Marginal Revenue = $Product Price
XXXXXXXXXXMR) = ($P)
Minimize $Total Loss where
$Price = $Marginal Cost
$Average Total Cost ($ATC)
Quantity of Output (Q)
$Product Price ($P)
Minimum Total Loss (Since TP<0, then it is below-normal)
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In Pure Competition, we can illustrate the scenario where an individual firm earns a normal (zero) level of Total Profit (TP). The firm’s profit = opportunity cost. In this scenario:
Firm produces Q* where P = MC to maximize total profit (zero is the maximum here).
At Q*, Product Price (P) = Average Total Cost (ATC)
When P = ATC, then TP = $0, and we say that TP is “normal”.
$Price per unit of Output
or $MC
Or $ATC
Q* for Total Profit Maximizing
$Marginal Cost ($MC)
$Marginal Revenue = $Product Price
XXXXXXXXXXMR) = ($P)
Maximize $Total Profit (TP=$0) where
$Price = $Marginal Cost
$Average Total Cost ($ATC)
Quantity of Output (Q)
$Product Price ($P)
Maximum Total Profit (Since TP = 0, then it is normal)
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The interaction of Costless Information, Free-Entry, Free-Exit and Total Profit levels in Pure Competition
The level of Total Profit earned by purely competitive firms is public, free and relevant information.
Over the long term, if purely competitive firms are earning above-normal total profit, then informed and profit-seeking entrepreneurs take advantage of “free entry” and join the industry in large numbers.
The new entrants add to the industry’s market supply, and the Market Supply function shifts to the right.
The increased market supply causes the market equili
ium product price to decrease.
As the market price falls, so does the Total Profit level for the purely competitive firms. As long as Total Profit is above-normal, free entry will continue to add new firms and expand the market supply. Continued →
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Scenario 1 - Effect of “Free-Entry” on market price (P) and the purely competitive firm’s total profit (TP):
When firm produces Q1* where $P1 = MC, then TP > 0 (Above-Normal).
Then Free-Entry causes an increased Industry Supply. Supply shifts right.
When new Market Price 2 established, then $P2 = MC, and TP = 0 (Normal).
$Price per unit of Output
$Price per unit of Output
Quantity of Output (Q) [100’s of Q]
Quantity of Output (Q) [Million’s of Q]
Entire Purely Competitive Industry
One Small Purely
Competitive Firm
in the Industry
Industry Supply 1
Industry Demand
Firm’s Initial $Price 1
$P1=MC
Industry Supply 2
$Price 2
Firm’s New $Price 2
$MC
$ATC
$Price 1
$P2=MC
Q1*
Q2*
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The interaction of Costless Information, Free-Entry, Free-Exit and Total Profit levels in Pure Competition (Continued)
When free-entry has increased the market supply sufficiently to cause the market price P to equal Average Total Cost (ATC), then TP drops to $Zero, and the free-entry of new firms stops because TP is simply “normal”.
Since TP now equals its opportunity cost, there is no longer any extra motive for new firms to enter the purely competitive industry. Entrepreneurs now look elsewhere in the economy to see if “greener pastures can be found”.
The Purely Competitive industry can stabilize where:
Price = Marginal Cost
Price = Minimum Average Total Cost
What happens in Pure