How a Firm Operates in a PerfectlyCompetitive Environment

Microeconomics Essentials

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Course: Microeconomics Essentials Lesson 4: How a Firm Operates in a Perfectly Competitive Market

Introduction to Perfectly Competitive Markets

When Pepsi's markets fluctuate in the short term, Pepsi responds with tactical pricing adjustments, and those adjustments fit within an overall pricing strategy. That strategy must reflect a view of the long run equilibrium of the market's supply and demand. The best way to anticipate that equilibrium is to first understand how supply and demand interact within the conditions of a perfectly competitive market, that is a market that's highly fragmented and in which no single seller or buyer has sufficient clout to affect the market price. Now, in fact, Pepsi does not operate in a perfectly competitive market. But for instructional purposes, we'll assume, one, that Pepsi uses sugar (and not high fructose corn syrup) to sweeten its cola, and, two, that the sugar suppliers operate in a perfectly competitive market.

Supply Curve for Price-Taking Firm

Do Coke and Pepsi compete fiercely with each other? Yes, the cola wars are legendary-and ongoing. But do Coke and Pepsi battle in perfectly competitive markets? No. They compete in an oligopolistic market under complex conditions that involve a variety of fascinating game theory gambits. (We'll get to that in the next module.) But it's hard to understand those complex market conditions without first understanding the conditions of perfectly competitive markets.

Pepsi's sugar suppliers provide a good example. Pepsi has many suppliers, each of whom sells the same, undifferentiated sugar product at a transparent market price. And each produces on a small scale relative to the overall market. Under these conditions of perfect competition, these sugar suppliers must accept the market price as given. These companies are price-takers, i.e., no supplier can price above the market without losing all sales volume to other suppliers. And pricing below the market would be folly; doing so would needlessly sacrifice revenue. Click on the graphic above to see a depiction of perfect competition.

FAQ

What is an undifferentiated product?

An undifferentiated product is one that consumers perceive as being identical. No one producer adds additional value to the product. These are also called commodities.

Price-Taking Firm

In a perfectly competitive market, since suppliers are price takers, a supplier's marginal revenue must equal the market price. We've seen that a business maximizes profits at the point at which marginal revenue equals marginal cost. So, if marginal revenue equals market price, and if marginal revenue equals marginal cost, it follows that a sugar producer will supply that quantity of sugar that corresponds to the point at which price equals marginal cost. For example, as illustrated above, when the market price is 10 cents per pound, a price-taking sugar producer would supply 60,000 metric tons of sugar annually.

FAQ

What is an example of how output quantity by an individual firm does not affect market price?

Producers of agricultural commodities find that their individual level of production cannot move the market price. An independent farmer, who raises corn or soybeans, cannot change the market price whether he farms 1,000 acres or 2,000 acres. He provides such a miniscule fraction of the total corn that is sold worldwide that any change in his individual volume of output is like a small drop in the ocean.

Price-Taking Firm

Assuming that P=MC, and assuming that the marginal cost curve is upward sloping, we can now graph a more detailed image of how a sugar supplier's optimal output will change as the market price changes. In other words, we can plot the supplier's supply curve.

With a knowledge of its supply curve, and with a view of where prices may trend in the foreseeable future, the sugar supplier can estimate a range of output levels where it is likely to want to produce. And with a solid estimate of output, the supplier can manage its production resources more effectively, project its production (and other) costs more accurately and develop more useful financial projections with which to manage the overall business.

Notice that this curve is upward sloping, i.e., the producer will supply more output only if the market price rises. Why is this? Recall that within a perfectly competitive market, P must equal MC. For a typical sugar producer, we would expect that it would become increasingly more costly to produce additional units of output. This is because in order to produce more output, the producer will have to deploy more land, and that land will likely consist of acreage whose lesser fertility (or greater distance from sources of irrigation) make it more costly to cultivate. Only a higher market price will induce the sugar producer to place this more-costly-to-cultivate-land into production.

FAQ

What is the profit-maximizing quantity for a perfectly competitive firm?

The profit-maximizing quantity of production for a perfectly competitive firm occurs where price equals marginal cost and marginal cost is increasing. If either of these conditions do not hold, the firm can increase its profits by producing at another level of output.

Exercise: Marginal Cost and Market Price

Answer

Exercise: Price-Taking Firm

Let's focus on firms that produce DRAM (dynamic random access memory) chips, semiconductors that are commodities, will sink a large initial investment into building a fab, the production facility for the chips. A fab has very few alternative uses. Firms will operate their fabs at close to full capacity as long as the market-driven prices of DRAMS cover the variable costs of production. The firms' variable costs are relatively low as a fraction of total costs and tend to vary in direct proportion to output. Mouse-over the images below and select the option that best describes the probable shape of the supply curve of an individual DRAM producer.

Market Equilibrium

Given the conditions of a perfectly competitive market, a sugar supplier has no control over the price of its product. So who, or what, determines the price of sugar? And why do we care?

It's the market that determines the price. And we care because if you understand the microeconomic principles by which markets set prices, you can formulate business strategy more effectively, whether we're doing that for companies like Pepsi, or its sugar suppliers, or any other kind of business in any industry and any market.

Stories

In a Downturn, The Strong Survive - But the Weak? Dell vs. HP in the PC Market

Continuing to feel the effects of weak demand and an industry wide price war, Dell Computer reported a 1% drop in sales revenues, but a 19% increase in unit shipments. Dell's operating profits weakened but remained in the black, thanks to increasingly aggressive cost-cutting initiatives and the efficiencies of its enviably high asset turnover.

Meanwhile, Hewlett-Packard (HP) reported that it lost money in the PC business on a sharp decline in unit shipments, which more than offset the effect of aggressive cost-cutting initiatives. HP also announced plans to institute "e-procurement" programs for streamlining buying supplies and parts, as well as plans to cut the number of its contract manufacturers from twenty to four. HP also reported that its consumer printer business continued to be profitable and did not lose market share

Dell's announcement confirms its standing as the industry's low-cost provider and its ability to lower its marginal costs to defend its market share and maintain profits while waiting out weak market conditions. In a commodity product market whose conditions approach those of perfect competition, that's essential.

Do HP's results in the PC business reinforce that proposition? And do its results in the consumer printer business suggest the benefit of having the leading share of a somewhat more differentiated market? And there's more to this story…

Hewlett-Packard (HP) announced its plan to merge with Compaq Computer Corp. in an effort to cut costs significantly and remain competitive in the personal computer business. The consolidation of the two companies should result in an overall cost savings of $2.5 billion. And since they are being squeezed in their core business, HP and Compaq's goal also includes reaching critical mass in higher-margin computer services. Wall Street has responded negatively to the proposed merger. Both HP and Compaq have lost money on their PC businesses in the last few years. As one analyst stated, "Two losers don't make a winner". By combining, they hope to reduce their unit costs and continue to compete with Dell. Time will tell if this strategy pays off in the ultra-competitive PC industry.

Commentary

I don't think there's a better technology example of perfect competition than personal computers. Products are undifferentiated and the market is highly fragmented. Even Dell, the nine hundred pound gorilla of this business, has less than 15% market share. The other thing that's neat about this example is that it shows the power of a cost advantage in a perfectly competitive market. In a perfectly competitive market, a cost advantage gives you an insurance policy in a situation in which prices are driven down to the average cost of the marginal producer. Cost is king in a perfectly competitive market, and the enormous success of Dell and the tremendous market valuation that it has generated over the years is testimony to that

FAQ

In a perfectly competitive market, is the marginal cost curve for a typical firm the same as the supply curve for the overall industry?

They are very similar, but not identical. Each firm's supply curve coincides with its own marginal cost curve. The aggregate supply curve for the industry is the sum of all the individual supply curves of producers and therefore is the sum of their marginal cost curves. While there may be slight variations in the marginal cost curves for each producer, when added together they represent the overall supply curve for the industry, and closely approximate the individual marginal cost curves.

Market Equilibrium

Markets set prices by balancing supply and demand. We've already seen the supply side of that equilibrium. And in the image above, we've added a demand curve for the sugar market. If the market is in equilibrium, the market will price sugar at the point at which the quantity supplied equals the quantity demanded. In the graph above, we see that this occurs at a price of 15 cents per pound.

At a higher market price, e.g., 20 cents per pound, supply would exceed demand and the surplus would push the market price down. And at a lower market price, e.g., 10 cents per pound, demand would exceed supply and the shortage would push the market price up. Only when the quantity supplied is equal to the quantity demanded is the market price steady. At this point we say that the market is in equilibrium.

Stories

It's The (Virtual) Pits: Perfect Competition within Financial Markets

As reported in the financial news, "The top executives of the Chicago Board of Trade ("CBOT") and the Chicago Board Options Exchange ("CBOE") have negotiated an end to their feud and, ultimately, their cooperation for sharing electronic trading privileges could lead to a merger or a strategic partnership.”

What's going on here, and what does it say about the cold realities of managing costs within conditions of perfect market competition? A little background first.

A long time ago, farmers and their customers worked out a way to share the risks inherent in the market for agricultural commodities; if the wheat crop were a bust, the resulting high prices would favor farmers and disfavor their customers, and vice versa with a bumper wheat crop.

To avoid that price uncertainty, the parties figured out a way whereby the farmer and his customer could agree today to a specified price at which the farmer would deliver, and the customer would accept, a specified quantity of wheat at a specified date in the future. This eliminated the price uncertainty and gave rise to the wheat futures market, and the corn futures market, and the pork bellies futures market, and so on.

Over in the capital markets, borrowers and lenders saw how this worked and, applying the same principles, created markets in financial futures and related products. As the world shrunk, the financial markets in Chicago integrated with those in New York, and then with those in London and Germany and Tokyo, and so on.

Originally, the parties to these deals met in person to transact. But the farmer's place is in the field, not the city, and a network of agents and brokers arose to facilitate both sides of the deals and to earn money of their own. Today, the world's leading financial markets use information technologies to move away from those agents and brokers so as to reduce the marginal cost of transacting. This trend is inexorable and accelerating, and the likes of the CBOT and the CBOE know that without investing in technologies that will minimize their marginal costs, they'll be marginalized by those who do, such as the Frankfurt market, which houses the world's largest futures exchange, the all-electronic Eurex.

Commentary

An important mechanism for moving a commodities market towards equilibrium is the network of brokers and agents that match buyers with sellers. As this example shows, these networks have become more sophisticated over time. As this happens, the model of a perfectly competitive equilibrium becomes a better and better description of how prices and commodities markets are determined. With information technology taking the place of human beings we can be virtually assured that equilibrium in a commodities markets, is attained in the twinkling of an eye.

Exercise: Demand and Market Equilibrium

Exercise: Market Equilibrium and Volatile Prices

The industry supply curve for DRAM producers has the same shape as the supply curve for the individual producer, although on a greater scale. Suppose that the market demand for DRAMs is volatile from quarter to quarter. Which of the graphs below summarize the typical evolution of the market price of DRAMs over time. (Assume that the scale of price over time for all three graphs is the same.)

Long-Run Equilibrium

What's wrong with this picture? It's the same one that we used to explain short-run market equilibrium, except that we've added an Average Cost curve. But notice that the current market price (and marginal cost) of 15 cents per pound exceeds the sugar supplier's average cost of 10 cents per pound at the current output level of 8.2 thousand metric tons per year. Under conditions of perfect competition, this market is unstable (i.e., it's not in long run equilibrium). Why not?

Because each sugar supplier is earning an economic profit, i.e., the current market price exceeds the average cost. In a perfectly competitive market, sugar suppliers can enter and exit at will. So if current conditions permit suppliers to earn economic profits, and if there are no barriers to entry, this situation won't last long; the prospects of earning economic profits will attract new suppliers to the market. And then what happens? Let's see.

FAQ

What would happen if the government imposed a ceiling on how high the price in the market could go?

If the government prevented a commodity from rising to its equilibrium price by mandating a maximum price, the producers of the commodity would not have an incentive to produce as much. A shortage of the good would occur, and quantity demanded would exceed the quantity supplied. Consumers who would like to buy the good at the controlled price would be unable to do so.

Long-Run Equilibrium

As additional sugar suppliers enter the market, the industry supply curve will shift outward, from SS to SS'. The market will balance supply and demand where the market price (i.e., marginal cost) equals the average cost of 10 cents per pound, which corresponds to an output level of 5.8 thousand metric tons per year. Now the market is stable, i.e., it's in long-run equilibrium; industry supply equals industry demand and each sugar supplier earns zero economic profit. There's no incentive for new suppliers to enter the market or for incumbent suppliers to leave.

Clearly, these are unforgiving market conditions. They compel each supplier to manage costs ruthlessly and they dispel any prospect for earning economic profits. But remember - these are conditions of a perfectly competitive market. They apply to Pepsi's sugar suppliers, who sell undifferentiated commodity products.

FAQ

In the sugar industry, the entry of additional firms could drive up prices of scarce resources, such as land. How would this affect the adjustment to a long-run perfectly competitive equilibrium?

If the prices of certain key resources, such as land, are bid up as new firms enter the industry in response to, say, an increase in demand, then the firm's average cost curve will shift upward. The point where marginal cost and average cost intersect will rise, and in the long run the market price will settle down at a higher level.

The theory of perfect competition seems to imply that in a long-run perfectly competitive equilibrium, firms earn zero net income. This doesn't seem to make sense - why would any firm operate in an industry in which it earns zero net income?

To answer this, let's review what we mean by economic cost and economic profit. Economic costs reflect the relevant opportunity cost of time and capital that the owner provides to the firm. Zero profit means zero economic profit, not zero accounting profit. Zero economic profit means that the owners of a firm are earning returns on their investment of time and money commensurate with what they could earn from their next best opportunity.

Exercise: Long-Run and Short-Run Equilibrium

Exercise: Market Demand Curve and Price