Price Taking on the Market - Essay Example

?Lessons 10, 11 and 12 Price Taking. Individual firms in a competitive market place lack the ability to set the market price, so they must acceptthe price the market offers; in other words, they are “price takers.” In a competitive marketplace, if such a firm were to attempt to raise prices other firms would be willing to undercut the new price, causing consumers to purchase the lower priced goods. Instead, each firm will produce at the level where its marginal cost equals marginal revenue, the price offered by the market. Given consumer behaviors such as brand loyalty, it is difficult to imagine that many if any perfectly competitive markets exist. Still, it seems likely to be a reasonable assumption to help understand market behavior. Industries in which there are many producers and in which it is difficult to differentiate between goods from individual producers, baking potatoes for example, it is likely that assuming the market is perfectly competitive can yield a reasonably accurate understanding of the way the market works. For markets, however, in which there are a limited number of producers and in which the costs to enter the market are high, or where the government restricts entry, it does not seem a reasonable assumption. Electric power, for instance, is often only available within a community from a single commercial producer. While there may be some alternatives available to consumers, such as buying their own generators or banks of solar cells, for all but the most committed, the price of these alternatives is so high as to make them non-viable. Clearly, for a market like this, assuming competitive behavior is not reasonable. 2. Profits. In a competitive market in long term equilibrium, no firm can make an “economic profit”—that is, have revenues in excess of costs, including “normal profit.” This is because economic profit will provide an incentive to other firms to enter the marketplace, shifting the industry supply curve and driving down the price until there is no longer an economic profit. In the short term, a firm may enjoy economic profits in the following three ways. The first way is when a firm might innovate in a way that drives down its costs of production. While other firms work to catch up, the innovative firm can enjoy economic profit. The second way is when a firm might innovate in a way that favorably differentiates its product from others, again allowing it to earn economic profit while other firms worked to match it. The third way is when an external event occurs, such as perhaps the introduction of a new complementary good, which might shift the demand curve for the good in question, allowing the entire industry to experience short term economic profits until more firms were able to enter the market and increase supply. 3. Shutdown point for a firm. In the short run, a firm should keep operating as long as its average variable costs are less than the price of its product. This is because total revenue will cover the variable costs. Since, in the short run, fixed costs are not avoidable they should not be considered. In the long run, the firm cannot continue to operate at a loss. This means that a firm should shut down and leave the industry if, over the long run, average total costs will exceed price. 4. Long-Run Cost Curve, Economies of Scale and Firm Size. A firm is enjoying economies of scale when long-run (i.e., all inputs variable) average costs decrease as the number of units produced by the firm increases. As demand for the product increases, a firm in this position is likely to be able to meet the additional demand at a lower cost than a new firm entering the market, providing the existing firm with a competitive advantage. To the degree the firms in an industry experience economies of scale, there will likely be fewer firms (i.e., increased concentration) then there would in an industry where firms were experiencing decreased returns to scale Taken to the extreme, an existing firm with a continuously declining long-run cost curve would be in a position to out-compete any other firm across the entire industry demand curve, creating the conditions for a natural monopoly. a. Examples: 1. Decreasing returns to scale. Past a certain point, an advertising firm may experience decreasing returns to scale. Such a firm's major input is skilled labor. As the firm grows, it must either substitute less skilled, less productive, labor, or pay more to compete for additional highly skilled labor. Also, the costs of managing a larger staff, the inefficiencies due to increased communications burdens among the staff members, etc. may well result in decreasing returns to scale. 2. Constant returns to scale. A mid-sized dairy operation may be in a portion of its long term average total cost curve where it can increase production by adding additional cows without changing the average total cost of producing a gallon of milk. 3. Increasing returns to scale. A firm such as Ford, as a small automaker in the past century, learned to produce its product more efficiently, and could enjoy increasing returns to scale over a portion of its long-run average total cost curve. b. Economies of scope. Economies of scope differ somewhat from economies of scale. While the later refers to decreases in average total cost enjoyed as the quantity produced of a single good increases, economies of scope refer to the decreases in average total cost as the quantity produced of two or more goods increase. An example might again be Ford Motor Company, where brand recognition and loyalty, common suppliers, and shared production expertise combine to provide economies of scope over several different product lines – passenger cars, SUVs, light trucks, etc. – that make it more efficient for these different products to be produced by a single firm than by individual, more specialized, firms. 5. Profit Maximization. In general, the assumption that all firms seek to maximize profits seems reasonable, though in practice it should be realized that many firms seek to maximize profits, given certain constraints. For example, a firm may seek to maximize profits so long as doing so does not violate the ethical principles of its management, or so long as its practices are consistent with the environmental concerns of its shareholders. One example of a firm that may not seek to maximize profits would be a not-for profit hospital. Nominally, such hospitals seem to seek to maximize patient care and service to their communities, as opposed to profits. Another example might be a local “homeless shelter.” Such shelters seem to rarely, if ever, run on a for profit basis. They seem to attempt to provide shelter, and, perhaps, food and clothing, to homeless individuals, using resources obtained by donations, corporate and government grants, etc. They would seem to be maximizing public perception of their ability to provide services to the most people for the fewest dollars. The ability of non-profit maximizing firms to survive in the long-run against profit maximizing firms in a competitive environment seems to be an open question. Certainly, in the case of not for profit hospitals, the history over recent decades suggests those that are successful in competitive markets have tended to adopt practices similar to those of their for profit competitors. Other, previously not-for-profit, hospitals have either closed or been taken over by for profit entities. 6. Fixed Costs and Entry. An industry with a high fixed cost to enter, but which is otherwise competitive, will tend to have firms with economies of scale over a large portion of their long-run average total cost curves. This is because the fixed costs will dominate the variable costs until after the fixed costs divided by the number of units produced drops below the marginal cost per unit. This will tend to lead to a market with fewer and larger, firms than one with lower costs of entry. That is because a firm that is already in production will have a significantly lower cost, for much of its cost curve, of producing an additional unit than a new firm would have to produce its first unit. a. Marginal cost, for an industry with a high fixed cost of entry, except for the first unit produced, will remain unchanged. Once the initial cost, perhaps of a permit, is paid, it is a sunk cost and should not be a consideration in future pricing and production decisions. All other assumptions of a competitive market should generally hold. It will be more costly for new firms to enter the market, so as demand shifts there would likely be some price increase as marginal costs for firms rise, up until it reached a level where new firms found the entry cost worthwhile. At that point, the price may well drop again. This could lead to a somewhat spikier industry supply curve than would be observed with a lower cost of entry. b. A restaurant is a business that is likely to have relatively high fixed costs of entry, given permitting and equipment costs. On the other hand, a child's lemonade stand probably has very low fixed costs, barring recent efforts in some communities to enforce health and permitting laws against ten-year-olds. That same lemonade stand is likely to have low variable costs as well. A jeweler, on the other hand, may face substantial variable costs for precious metals, gems, and other materials needed to produce fine jewelry. c. In Texas, restaurants face a higher fixed entry cost but a lower marginal cost in the margarita market than restaurants in other states. As such, we would expect that there would be fewer restaurants serving margaritas in Texas. Those restaurants would tend to be larger, anticipating serving a larger number of drinks at a lower price than a restaurant in the other state. Read More