Chapter 9 - Competitive Markets: Theory and Applications (Chapter 9 Study Notes)

Competitive Markets

9.1 Market Structure and Firm Behaviour

This section introduces the concept of market structure and its influence on firm behaviour and market outcomes. The degree of competitiveness in a market determines how much influence individual firms have over prices.

• Competitiveness of the Market: Refers to the influence that individual firms have on market prices. The less power a firm has, the more competitive the market.

• Zero Market Power: In a perfectly competitive market, firms have no power to influence the market price and can sell as much as they want at the prevailing price.

Competitive Behaviour: The degree to which firms actively compete for business. Not all competitive behaviour occurs in competitive markets (e.g., MasterCard and Visa compete, but their market is not perfectly competitive).

• Example 1: MasterCard and Visa compete, but their market is not competitive.

• Example 2: Wheat farmers do not actively compete, but their market is highly competitive.

Significance of Market Structure: Market structure affects the efficiency of the market and the demand curve faced by individual firms versus the industry as a whole.

9.2 The Theory of Perfect Competition

This section outlines the key assumptions and implications of perfect competition, a theoretical benchmark for market analysis.

• Assumptions of Perfect Competition:

  1. All firms sell a homogeneous product.

  2. Customers have perfect information about products and prices.

  3. Each firm’s minimum Long-Run Average Cost (LRAC) is small relative to total industry output.

  4. Firms are free to enter and exit the industry.

  Implication: Firms are price-takers—they accept the market price as given.

The Demand Curve for a Perfectly Competitive Firm

• The industry demand curve is downward sloping, but the individual firm faces a horizontal demand curve at the market price.

• "Normal" changes in a single firm's output have negligible effects on the market price.

• Example: If a farmer increases output by 200%, the effect on market price is only 0.0016%, resulting in a price elasticity of demand for the farmer of 125,000—essentially perfectly elastic demand.

Key Questions

1. If a firm charges a higher price than the market, it will sell nothing because buyers can purchase identical products elsewhere for less.

2. If a firm charges a lower price, it gains nothing because it can sell all it wants at the market price.

3. The demand curve is horizontal because the firm is a price-taker; it cannot influence the market price.

Total, Average, and Marginal Revenue

• Total Revenue (TR): $TR = p \times q$

• Average Revenue (AR): $AR = \frac{TR}{q} = p$

• Marginal Revenue (MR): $MR = \frac{\Delta TR}{\Delta q} = p$

• For a perfectly competitive firm, $AR = MR = p$

9.3 Short-Run Decisions

Firms in the short run aim to maximize profits, which is the difference between total revenue and total cost.

• Profit: $\text{Profit} = TR - TC$

• As output changes, both costs and revenues change.

Should the Firm Produce at All?

• If the firm produces nothing, it still pays fixed costs (TFC).

• If it produces, it pays variable costs (TVC) and receives revenue (TR).

• Production Rule: Produce only if, at some output, $TR > TVC$ (or equivalently, $p > AVC$).

• Shut-Down Price: The price at which the firm just covers its average variable cost (AVC). At this price, the firm is indifferent between producing and shutting down.

Table: Should the Firm Produce at All?

Q	TVC	TFC	TC	TR (Low $2)	Profit (Low)	TR (High $5)	Profit (High)
0	0	200	200	0	-200	0	-200
10	50	200	250	20	-230	50	-200
20	80	200	280	40	-240	100	-180
30	110	200	310	60	-250	150	-160
40	130	200	330	80	-250	200	-130
50	160	200	360	100	-260	250	-110
60	200	200	400	120	-280	300	-100
70	260	200	460	140	-320	350	-110
80	320	200	520	160	-360	400	-120
90	380	200	580	180	-400	450	-130
100	430	200	630	200	-430	500	-130

Additional info: Table illustrates how profit changes with output and price, showing the importance of covering variable costs in the short run.

Profit Maximization Rule

• To maximize profit, the firm chooses output where $MR = MC$.

• For a competitive firm, $MR = p$, so the rule becomes $p = MC$.

• If $MR > MC$, increase output; if $MR < MC$, decrease output.

Short-Run Supply Curve

• A competitive firm's supply curve is its marginal cost (MC) curve above the minimum of the average variable cost (AVC) curve.

• The industry supply curve is the horizontal sum of all firms' MC curves above AVC.

Short-Run Equilibrium in a Competitive Market

• Market price clears the market (quantity supplied = quantity demanded).

• Each firm maximizes profit at this price.

• Profit Calculation:

  • $\text{Profits} = TR - TC = (p \times Q) - (ATC \times Q) = (p - ATC) \times Q$

  • Profits per unit: $p - ATC$

• Three cases:

  1. Zero Economic Profits: $p = ATC$

  2. Positive Economic Profits: $p > ATC$

  3. Negative Economic Profits (Losses): $p < ATC$

9.4 Long-Run Decisions

In the long run, firms can enter or exit the industry, and all costs are variable. The industry reaches equilibrium when no firm has an incentive to enter or exit.

• In long-run equilibrium, all firms:

  • Maximize profits

  • Earn zero economic profits ($p = ATC$)

  • Operate at the minimum point of their LRAC curve

  • Cannot increase profits by changing the size of their production facilities

Entry and Exit

• Positive economic profits attract new firms (entry), increasing supply and lowering price until profits are zero.

• Economic losses cause firms to exit, reducing supply and raising price until losses are eliminated.

• Zero profits mean no incentive for entry or exit.

Changes in Technology

• Technological improvements reduce costs for new plants, allowing them to earn profits and expand output.

• Market price falls to the SRATC of new plants; old plants may operate temporarily if $p > AVC$, but will eventually exit if they cannot cover long-run costs.

• Long-run equilibrium is restored at a lower price and higher output.

Declining Industries

• If demand continually decreases, firms reduce output and capacity as long as variable costs are covered.

• Antiquated equipment is often a result, not a cause, of industry decline.

Summary Table: Short-Run and Long-Run Equilibrium

Condition	Short-Run Response	Long-Run Response
Positive Economic Profits	Firms earn profits; no entry in SR	New firms enter, supply increases, price falls, profits go to zero
Zero Economic Profits	Firms cover all costs; no entry/exit	No entry/exit; equilibrium maintained
Economic Losses	Firms incur losses; no exit in SR	Firms exit, supply decreases, price rises, losses eliminated

Key Formulas

• Total Revenue: $TR = p \times q$

• Average Revenue: $AR = \frac{TR}{q} = p$

• Marginal Revenue: $MR = \frac{\Delta TR}{\Delta q} = p$

• Profit: $\text{Profit} = TR - TC$

• Profit per unit: $p - ATC$

Practice Questions

• What are the four key assumptions of perfect competition?

• Why is the demand curve for a perfectly competitive firm horizontal?

• How does entry and exit restore long-run equilibrium in a competitive industry?

• What is the shut-down price, and how is it determined?

Additional info: These notes synthesize textbook slides and lecture content, expanding on definitions, examples, and formulas for clarity and exam preparation.