Chapter Ten Notes - Della PDF

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1 Chapter Ten – Price-Searcher Markets with Low Entry Barriers Competitive Price-Searcher Markets  Firms in competitive price-searcher markets with low entry barriers face a downward sloping demand curve o Firms are free to set price, but face strong competitive pressure o Competition exists from existing firms and potential rivals o An alternative term for such markers is monopolistic competition Product Differentiation  Price searchers produce differentiated products – products that differ in design, dependability, location, ease of purchase, etc. o 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 o Price will be lowered and output expanded until MR = MC  The price charged by a price searcher will be greater than its marginal cost Profits and Losses in the Long Run  If firms are making economic profits, then rival firms will be attracted to the market o The entry of new firms will expand supply and lower price o 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 o Demand for the remaining firms’ output will rise until the losses have been eliminated, removing 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 Long Run in a Competitive Price-Searcher Market  Because entry and exit are free, competition will eventually drive prices down to the level of ATC  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 with MC = MR Contestable Markets  A contestable market is one in which entry and exit costs are low and there are no legal barriers to entry: o Example: Airline industry  Actual and potential competition leads to: o Zero economic profits o Efficient production

2 Price Discrimination  Price Discrimination o When a seller charges different consumers different prices for the same good or service o Price discrimination can only occur when a price searcher is able to:  Identify groups of customers with different price elasticities of demand, and,  Prevent customers from re-trading the product  Sellers may gain from price discrimination by charging o Higher prices to groups of customers with more inelastic demand, and o Lower prices to groups of customers with more elastic demand  Price discrimination generally leads to more output and additional gains from trade Entrepreneurs  Entrepreneurship o Entrepreneurial judgment and the development of improved products and production processes are a central element of economic progress o Entrepreneurial judgment is necessary when there is no decision rule that can be applied using only information that is freely available o For this reason, we are unable to incorporate fully the function of the entrepreneur into economic models o There simply is no way to model these complex decisions that involve uncertainty, discover, and business judgment Entrepreneurs and Economic Progress  An entrepreneur is someone who finds new combinations of resources and creates new products and production methods that did not previously exist  Entrepreneurs who discover and introduce lower-cost production methods and new products that are highly values relative to cost promote economic progress  Entrepreneurs also have a strong incentive to discover the type of business structure, size of firm, and scope of operation that can best keep the per-unit cost of products or services low  A growing, vibrant economy will be characterized by the constant introduction of new products and services  Nobody knows what the next innovative breakthrough will be or who will discover and develop it  The only real test of a new product or service is to try it out within the framework of the competitive market process  The rate of discovery will depend on the structure of rewards. In economies where it is attractive to discover new ways of doing things, the discovery rate of wealth creating opportunities will be higher and human progress more rapid

3 Dynamic Competition, Innovation, and Business Failures      

Business failures are usually reported as bad news about the economy Though business failures are painful for those directly involved, they release resources so they can be employed more productively elsewhere The assets and workers of failed firms become available for use by others supplying goods that consumers value more relative to costs Without this release of resources, economic expansion would be slowed The introduction of new and improved products often leads to obsolescence of others. Joseph Schumpeter referred to this process as “creative destruction” In a competitive economy, numerous businesses regularly come and go. Each year newly created businesses account for about 10% of the total but 60% of them will fail within six years

4 Key Points  Firms in price-searcher markets with low barriers to entry face a downward-sloping demand curve/ they are free to set the prices for the products that they sell but face strong competitive pressure from existing and potential rivals  Firms in price searcher markets with low entry barriers use product quality, style convenience of location, advertising, and price as competitive weapons. Because each firm competes with rivals offering similar products, each confronts a highly elastic demand curve for its products  A profit-maximizing price searcher will expand output as long as marginal revenue exceeds marginal cost, lowering its price in the process until MR = MC. The price charged by the profit-maximizing price searcher will be greater than its marginal cost  Firms in competitive price-searcher markets can experience either profits or losses in the short run. Profits will attract rival firms into the market until supply increases and the profit-maximizing price falls to the level of per-unit price. Losses will cause firms to exit the market until the price increases enough that the remaining firms can once again cover their per-unit costs. Because of the low entry barriers, the firms in competitive pricesearcher markets will earn only normal returns (zero economic profit) in long-run equilibrium  Competition can come from potential as well as actual rivals. If entry and exit can be arranged at low cost, and if there are no legal barriers to entry, the theory of contestable markets indicates that competitive results will be approximated, even if there are only a few firms actually in the market  Competitive price-searcher markets provide more variety but may raise costs relative to price-taker markets because (1) price exceeds marginal cost at the profit-maximizing output level, (2) long-run average cost is not minimized, and (3) advertising is costly. When barriers to entry are low, however, price searchers have an incentive to (1) produce efficiently; (2) undertake production if, and only if, their actions are expected to increase the value of the resources used; and (3) be innovative in offering new product options  When a price searcher can (1) identify groups of customers that have different price elasticities of demand and (2) prevent customers from retrading the product, price discrimination may emerge. Sellers may be able to gain by charging higher prices to groups with a less elastic demand and lower prices to those with a more elastic demand. The practice generally leads to a larger output and more gains from trade than would otherwise occur  Entrepreneurs discover previously unnoticed profit opportunities and act on them. By discovering and developing new products that are highly valued relative to cost, entrepreneurs promote economic progress. The profit and loss system provides entrepreneurs with quick and persuasive feedback on the merit of their idea  Entrepreneurship is an inherently disruptive force in an economy as new products often cause the failure of old ones. But this creative destruction is an important source of improved products, lower costs production methods, and higher living standards...