Price takers just take the market price - there is no pricing decision, no advertising, no marketing, etc. They can adjust their output (expand/contract) and they can try to reduce costs of production, but they have no pricing decision.
We now look at Competitive Price-Searcher Markets,
1) firms face a downward sloping demand curve for their product or service, and
2) there is easy entry/exit. With low entry barriers, the smell of profits will attract competition.
Price-searching firms face a more complex set of decisions - see opening quote. Firms never really directly observe demand curves, so they have to engage in a process of trial-and-error to search for the price that maximizes profits. Since markets are continually changing, the price searching process is continual and ongoing, e.g. airlines, long distance, computers, online services, etc.
Firms are now selling differentiated products with brand names and have pricing decisions - how to market, advertising, bundling (computer + printer), specials, discounts, promotions, rebates, coupons, quantity discounts, senior citizen discounts, price discrimination, etc.
However, there are usually many close substitutes so these markets are competitive - fast food, cell phones, airlines, computers, athletic shoes, etc. A price-searching firm can raise its prices and NOT lose all its customers, unlike a price-taker. However, because there are lots of close substitutes, the demand curve facing an individual firm will be highly ELASTIC.
The firm faces competition from two sources:
1) all existing firms and
2) potential rivals or competitors who will enter the industry if profits are high, e.g. coffee shops, online services. "The smell of profits."
Firms can set price, but then market forces determine how much is actually sold at a given price. Firms attempt to find the Price-Quantity combinations that MAX PROFITS.
Firms also can control more than just Price, they can
control other non-Price factors that affect consumer value: Quality, location,
service, advertising, convenience, bonuses (frequent flier miles), etc.
Main Point: price-searching firms face a complex set of
decisions, compared to price-taker.
PRICE AND OUTPUT
How does a price-searcher decide on the Price-Output combination that MAX PROFITS?
A firm faces a trade-off when changing its price. If price is lowered, more units are sold, but at a lower price for ALL units. If price is raised, fewer units are sold, but at a higher price for ALL units. See page 238. Firm lowers price from P1 to P2 and output expands from q1 to q2. There are two effects:
1. (P2 - P1) x q1 = Loss of Total Revenue from selling the original units (q1) at a new lower price (P2), since the new price (P2) applies to both new customers and old customers.
2. (q2 - q1) x P2 = Gain in Total Revenue from attracting
more customers (q2 - q1) times the new Price (P2).
Because of these conflicting forces on TR, the marginal revenue (MR) will always be less than Price, and the MR curve will always be below the Demand curve, see page 238.
PROFIT MAX RULE: Expand output as long as MR > MC. See page 239. At all units up to q, MR > MC, which increases profits. Beyond q, MC > MR, which will reduce profits. Firm should produce q units to Max Profits (Min losses).
1. MR = MC determines profit maximizing (loss minimizing) level of output.
2. Based on Profit Max output level q, we can determine the price (P) from the Demand curve (d).
3. Based on P, we can determine profits (losses) by comparing P vs. ATC.
On page 239, TR = 0PAq and TC = 0CBq. Since TR - TC = PROFITS, the yellow shaded area represents the economic profits.
The Economic Profits of the firm will now attract competition into the market since barriers to entry are low - competitors will expand output and new firms will enter the industry. Eventually, other firms will take away some the original firm's business and the demand curve will shift back until the firm will just cover its costs of production and P = ATC as on page 240. Economic profits will be zero and there will be no more pressure to enter the industry.
In the long run, the price-searching firm will look like page 240. P = ATC, firms are covering all costs of production (including opp costs of capital, etc.), economic profits are zero, firms are earning a risk-adjusted normal rate of return.
In the SR, price-searching firms can either make economic profits or economic losses. Economic profits attract entry and drive prices down to ATC. Economic losses cause competitors to leave the industry, surviving firms can eventually raise prices to cover ATC, economic profits will return to zero.
LR = Zero Economic Profits = Risk-adjusted Normal Rate
of Return = Rate-of- Return Equalization Principle.
Very competitive price-searching markets where:
1. Barriers to entry and exit are low. Easy for
firms to enter/exit the industry.
2. Zero economic profits in LR (P = ATC)
3. Minimum cost/most efficient method of production will prevail since both high prices and high/inefficient production costs will attract entry.
Potential, as well as current/existing competition will discipline firms in contestable markets. Implication of this is that even an industry with one dominant firm (software industry, Microsoft) can be contestable (competitive) if the threat of competition is sufficient to discipline the dominant firm. The dominant firm has incentive to keep prices so low that no other firm can successfully challenge their position. Example: Alcoa Aluminum.
Policy implication: If an industry is seen as not sufficiently competitive, we should look at what can be done to make the industry more contestable. What barriers to entry exist that can be removed or reduced? In many cases the way to make the industry more competitive is to DEREGULATE the industry, since regulations form a barrier to entry.
Occupational Licensing - MDs , JDs Barbers, etc.
THE LEFT-OUT VARIABLE: ENTREPRENEURSHIP
Our economic model provides a general framework for analyzing the decision making elements common to all firms - sole proprietorships to GM and Microsoft. What we can accurately model is the general behavior that describes Profit Maximizing behavior by firms. We know that successful firms do something that accounts for their business success over time - Microsoft and GM engage in decision making that is consistent with our economic models even though Bill Gates may have never taken an economics class. Many successful entrepreneurs make decisions intuitively, and pure entrepreneurial behavior can not accurately be modeled with graphs and equations. There is no way to precisely model complex decision making of an entrepreneur involving uncertainty, risk, discovery, innovation, creativity, etc.
Entrepreneurs are at the center of economic activity in the real world, even though they are not in economic models. Business is part art and part science, we can model the scientific part much easier than the part of business that is an "art."
Music example. We can study and analyze Mozart
or Beethoven, put their music into a formal musical model of sheet music,
musical notation, musical score, etc. We don't try to model the creativity
behind the music, we just respect it and appreciate it. Same thing
for business. See page 244-245 for discussion of four entrepreneurs.
PRICE-TAKER AND PRICE-SEARCHER MARKETS
See page 247.
Similarities between Price-Taker and Price-Searcher Markets
1. P = ATC, Economic profits are 0. Competition prevents positive economic profits in LR. Firms have strong incentive to operate as efficiently as possible, try to lower ATC, to make SR profits.
In both markets, an increase in demand will result in: higher prices, SR economic profits, expansion of output by existing firms, and entry by new firms, increase in market supply, downward pressure on price, price will eventually fall to ATC, all SR economic profits will be squeezed out.
1. For price-taker market, P = MC, for Price-Searcher Market P > MC.
2. For price-taker market, output level minimizes ATC, for Price-taker market, output does not minimize ATC.
3. Price is slightly higher in the Price-Searcher Market for identical cost conditions.
Debate: Are price-searcher markets inefficient?
Conventional View: Prices are higher, due to costly replication, too many firms operating below the capacity that would min ATC. Example: too many small gas stations and convenience stores located too close together, resulting in higher prices than if there were fewer, large gas stations and grocery stores spread further apart.
Also, conventional view says that firms waste money trying to differentiate their products and spending money on advertising, resulting in higher prices for consumers.
Modern View: Even though prices might be slightly higher, consumers receive benefits from price-searcher behavior. Advertising is costly, but consumers value the information transmitted by advertising, it reduces search time, gives valuable information about new products and new firms, etc. Consumers also benefit from differentiated, brand-name products even though prices are higher - consumers value designer clothing even though prices are higher. Consumers value unique products that may reflect their personality.
Example: vehicles. Consumers value a wide selection of vehicles even though prices are higher than if we all were willing to accept a standardized vehicle in one color with a standard set of options, etc. Consumers also value the convenience of having many gas stations, convenience stores, fast food restaurants, etc even if prices are slightly higher, compared to the alternative: fewer stores, more congested, located further apart.
And if consumers don't value higher priced differentiated
brand name products that are heavily advertised, they can always buy low
priced, generic products.
SPECIAL CASE: PRICE DISCRIMINATION
So far, we have always assumed that there is a single price and that all consumers pay the same price - the Market Price. Price discrimination is where the firm charges different customers different prices for the same product or service.
Examples:airfares, coupons, senior citizen discounts, tuition, car sales, weekend specials at hotels or ski resorts, telephone service, etc.
Price Discrimination involves:
1. Identify and separate two or more groups with different elasticities of demand. Charge a higher price to the group with the more INELASTIC demand, a lower price to the group with more ELASTIC demand.
2. Prevent resale from the Elastic group (low price) to the Inelastic group (high price).
3. Control resentment, so that the Inelastic group doesn't resent paying higher prices.
Example: page 249, Airline fares. Panel a, shows a uniform, single price of $400 per ticket, and output of 100 passengers, for TR = $40,000. That is the Profit Max level of output, where MR = MC. MC is fixed at $100/person, so that costs are $10,000 (100 passengers x $100), operating profits are $40,000 - $10,000 = $30,000.
Panel b - airline now has two prices, $600 for traveler's with Inelastic demand, mostly business travelers, or those who have to travel at the last minute, etc. Fares are reduced to $300 for traveler's with Elastic demand - tourists, students, vacationers, etc. To get the low price, you must make reservations far in advance, have flexible travel dates, fly during off-peak hours, stay over a weekend, etc.
Result: 60 people fly for business, pay $600
and 60 people fly for leisure pay $300. Total Revenue is now: (60
x $600) + (60 x $300) = $54,000. Costs are: 120 x $100 = $12,000,
leaving $42,000 in operating profits.
Bottom Line: Using price discrimination,
the airline raises TR by $14,000 and operating profits by $12,000.
Price discrimination can increase profits. Also, output is increased,
in this case, from 100 passengers to 120 passengers. This increase
in trade can increase the overall gains from trade, increases welfare.
And in some cases, price discrimination might allow trade/production to
take place where none would otherwise occur. Example: small
in Montana may only be able to attract a physician if they can price discriminate,
charge higher prices to higher income patients.
COMPETITION INCREASES PROSPERITY
1. Competition forces producers to operate efficiently and cater to consumers, weeds out the inefficient, reward the firms who are successful at pleasing consumers. What makes McDonald's, Wal-Mart, GM successful? Competition. If they try to raise prices, offer poor service, low quality products, consumers will to Burger King, Target or Toyota.
2. Competition provides strong incentives to operate efficiently and to constantly innovate, either to improve production, raise quality, develop new products. Think of all the money spent on research and development, firms are in a constant process of innovation, trying to develop and make new products - microwave ovens, fax machines, cell phones, CD players, VCRs, bypass surgery, etc. The role of the entrepreneur is to engage in the discovery process, finding new products that create value for consumers. Entrepreneurs must face the market test - "reality check" imposed by consumers.
3. Competition also forces firms to discover the most efficient type and size of business organization that creates value for consumers. Market economy does not impose a certain size on producers, firms can operate as sole proprietorships or huge conglomerates with thousands of employees - GM, Coca-Cola, etc. Efficient organizations will be rewarded and inefficient ones will be penalized. If a firm is too large or too small, and unit costs are high, the firm will be penalized with losses. Part of the competitive market process is searching for the most efficient form of business organization that will result in the lowest ATC/unit.
Examples: Assembly line production, JIT Inventory, Modular assembly, Downsizing, Restructuring, Internal vs External production, etc.
Summary: Competition harnesses personal
self-interest and promotes a higher standard of living. Rival firms
struggle for the dollar votes of consumers. Continual market referendum
on consumer preferences. Market economy as a "virtual voting booth."