Extreme Markets I: Perfect Competition Chapter 5 1 (c) 2010 Cengage Learning. All Rights Reserved....

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1

Extreme Markets I: Perfect CompetitionChapter 5


2

INTRODUCTION


3

The Ethanol UpheavalIn 2005 federal law began requiring that

refiners add “renewable”

ethanol into the nation’s

gasoline supply. Thisrequirement raises

thedemand for corn,

andsubsequently its

price.


4

What’s Ahead

This chapter is about perfectly competitive markets, in which individual producers are so small relative to

the market that each of them is a price-taker that cannotaffect price by changing its output.


5

DEFINING THE MARKET


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Substitutes and Competition – Preferences and Prices

Substitutes help determine competition. A set of producers is competitive if each supplies a good

substitute for what the others produce.


7

Substitutes and Competition – Who Competes with Coke?

Does Coke compete with other carbonated beverageproducers like Pepsi and Dr. Pepper, or with the producersof other beverages ranging from juice to bottled water?


8

Price-Takers and Monopolies

Whatever a firm produces, their strategies are constrained by customers’ abilities to

substitute and the abilities of rivals to expand or enter the industry. A firm’s tactics to

obtain an advantage next month may center on one subset of these factors, while a very

different group of factors will help determine their strategy for the next decade.


9

PERFECTLY COMPETITIVE MARKETS


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What We Assume, and WhyThere are many sellers, all of whom are price-takers.

No seller is large enough to affect market price by its own actions.

Each seller produces a good or service that is perfectly interchangeable with the output of any other; in other words,

the product is homogeneous.

Firms are not restricted from entering or leaving the industry in response to profits or losses.

There are no important transaction costs. In particular, information is available to all participants at no cost. Without

cost, buyers can learn the asking prices of sellers and sellers cancompare the bids of buyers.


11

The Short Run and the Long Run

In the short run, all firms in the market have somefixed inputs that must be paid for, regardless of whether

they are producing. In the long run all inputs are variable,and fixed costs need no longer be incurred.


12

MARKET ADJUSTMENT


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Identical Firms – A Shift in Demand

Initial long-run equilibrium is at 10,000 units produced in the market selling at a price of $7.00. Individual firms will each produce 10 units.

When there is a permanent increase in demand to D2, price will rise to $16.00 and existing firms will expand production to 11 units. Profit will

attract entry whichwill only stop when the market supply curve has shifted to SRS1500 and

the market price has once again fallen to $7.00.


14

Identical Firms – An Increase in Variable Costs

Here we begin in long-run equilibrium where the SRS1500 intersects the LRS at15,000 units selling for $7.00. Each firm produces 10 units.

An increase in variable costs shifts the individual firm’s cost curves to MC’ and AC’.The market supply curve shifts to SRS’1500. Price begins to rise above $7.00 but

firms are losing money and begin to exit the industry. Exit continues until market supply is SRS’1100 and price rises to $16.00.


15

Dissimilar Firms – A Shift in Demand

Here there are two types of firms facing different costs. If themarket demand curve is D1 only type A firms will exist in the

market. Demand would have to rise to D3 to attract type B firmsinto the market.


16

CASE STUDIES


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Ethanol Again – Long-Run Adjustment

Say there are a small number of low-cost Type A producers and a limitlesspotential number of high-cost Type Bs. We start in 2005 along demand curve

D1 at long-run equilibrium of 7,000 (million) bushels at a price of $7. Theethanol requirement increases demand to D3.

With just type A firms the supply curve shifts to SRS1000, causing price to rise to$22. This begins to attract type B firms to the industry and the entry of type B

firms will continue until price falls to $16.


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Ethanol Again – Corn Prices


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Ethanol Again – The Tortilla Effect

The graph on the left represents the market for corn in the US and the one on the right the market in Mexico. Initially, suppose both markets are in equilibrium at a price of $10. The ethanol regulation increase the demand for corn in the US to D2

US. The price for corn in the US rises to $16. Mexican producers have an incentive to export corn.

Eventually, the price of corn will settle at $13. The USwill produce 40 bushels for themselves and import 30 bushels from

Mexico.

Mexicans are unhappy when the price of corn tortillas also increase!


20

Oil and GasolinePictured is a simplified market forgasoline in the US. The domestic

demand is D. US refiners canproduce up to 1000 barrels at amarginal cost of $7. Assume USdemand is small relative to global

demand so the US has little impacton overall world demand.

Market price of $11 per barrelprevails with 1500 barrels per

day, 1000 produced domesticallyand 500 barrels imported.


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Oil and Gasoline – Effect of Government Policies

In this example, domestic producers produce at a marginal cost of $7 and receive a price of $11 per barrel, for a profit of $4 per barrel. Suppose a domestic

windfall profits tax of $4 is imposed, who benefits?

The price of gasoline will not change. Instead of producers,

the government will receive the $4 per barrel.


22

Oil and Gasoline – Political Platforms

Suppose that US policy increaseddomestic exploration. The

US supply curve would shift tothe right, reducing imports but

having no effect on the worldprice.

Extreme Markets I: Perfect Competition Chapter 5 1 (c) 2010 Cengage Learning. All Rights Reserved....

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