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UNIT 8 - CHAPTER 22 Powered By Docstoc

Firms who are 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 (corn farmer).

We now look at Competitive Price-Searcher Markets, where:
1) firms face a downward sloping demand curve for their product or service, and
2) there is easy entry and 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 on p. 490. 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 price-searcher markets are highly
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 price-search firm will be highly ELASTIC.

The firm faces stiff competition from two sources:
1) all existing firms in the industry 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.


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
Exhibit 1, page 492. Firm lowers price from P1 to P2 and output expands from q1 to q2. There are two

MGT 551: BUSINESS ECONOMICS CH – 22                                                 Professor Mark J. Perry
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

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 Exhibit 1, page 492.

PROFIT MAX RULE: Expand output as long as MR > MC. See Exhibit 2, page 493. 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).

General Procedure:
1. MR = MC determines profit maximizing (loss minimizing) level of output (q or Q*).
2. Based on Profit Max output level (q or Q*), we can determine the profit-maximizing price (P*) from
the Demand curve (d).
3. Based on P*, we can determine profits (losses) by comparing P* vs. ATC.

Exhibit 2 on page 493: TR = 0PAq and TC = 0CBq. Since TR - TC = PROFITS, the brown shaded
area represents Economic Profits.

The positive 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 Exhibit 3, page 494. Economic Profits
will be zero (TR = TC; and P = ATC) and there will be no more pressure to enter the industry.

In the long run, the economic conditions of a representative competitive price-searching firm are
illustrated in Exhibit 3 page 494. P = ATC, firms are covering all costs of production (including opp
costs of capital, etc.), economic profits are zero, firms are earning a positive, 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


The profit-loss system imposes strict discipline on firms. Firms that suffer economic losses must
eventually fail and go out of business. Business failures, although painful for workers who lose their
jobs, and investors and creditors who lose money, play an important role for the economy as a whole.

MGT 551: BUSINESS ECONOMICS CH – 22                                                Professor Mark J. Perry
Business failures free up and release valuable and scarce resources (labor, land, capital, credit, real
estate, machinery, etc.), that then become available for use by others in the economy who can use them
more productively. Reallocation of resources away from inefficient uses to more efficient uses.
Without the release of these resources, economic expansion for profitable firms and the whole
economy would be slower. Point: Business failures don't destroy the assets of the firm or the talents of
the workers, they are released for use by other more profitable and successful firms. In the long run,
even many of the workers are usually better off.

Examples: McDonald's vs. Sandy's and Henry's. Venture capitalist activity in Russia.


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 competition, 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. Deregulation (regulation) makes markets more
(less) contestable, more (less) competitive.

Airline Industry
Occupational Licensing - MDs , JDs Barbers, etc.
Handicap Accessible
Car Wash
Shoe Shine


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

MGT 551: BUSINESS ECONOMICS CH – 22                                                Professor Mark J. Perry
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. Even though we don't model
entrepreneurship, the role of entrepreneurs as "agents of economic progress" is very clear.

Entrepreneurship and Economic Progress:

Quote (p. 499): "The entrepreneurial discovery and development of improved products and production
processes is a central element of economic progress." In a dynamic, highly competitive economic
system, the role of entrepreneurs is critical and highly important. The market economy, more than any
other economic arrangement, nurtures, promotes and supports entrepreneurial talent. Economy vs.
sports example - discuss in class.

See story on "Five entrepreneurs who have changed our lives," p. 500-501.


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 ($1 vs. 97 cents for Price-Taker) for identical
cost conditions.

Debate: Are competitive Price-Searcher markets inefficient?

MGT 551: BUSINESS ECONOMICS CH – 22                                                Professor Mark J. Perry
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.


So far, we have always assumed that there is a single price (P) and that all consumers pay the same
price - the Market Price (P). Price discrimination is where a 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 for business vs. residential, etc.

Price Discrimination involves:
1. Identifying and separating 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
2. Preventing resale from the Elastic group (low price) to the Inelastic group (high price).
3. Controlling resentment, so that the Inelastic group doesn't resent paying higher prices. (not in book)

Example: page 505, 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 those costs are $10,000 (100 passengers x $100), operating profits are $40,000
- $10,000 = $30,000.

MGT 551: BUSINESS ECONOMICS CH – 22                                               Professor Mark J. Perry
Panel b - airline now has two prices, $500 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,

Result: 60 people fly for business, pay $500 and 60 people fly for leisure pay $300. Total Revenue is
now: (60 x $500) + (60 x $300) = $48,000. Costs are: 120 x $100 = $12,000, leaving $36,000 in
operating profits.

Bottom Line: Using price discrimination (two prices instead of one price), the airline raises TR by
$8,000 and operating profits by $6,000. This example illustrates the general principle that price
discrimination can increase profits. Also, the more price discrimination the firm uses, the higher the
potential profits. Going from one price to two prices raised profits, going from two prices to three could
raise profits even higher, and then why not try 4 prices, 5 prices, 6 prices, etc. Airlines are masters of
price discrimination.

Also, in this case, output increased, from 100 passengers to 120 passengers, volume of trade (air travel)
increased. 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 town in Montana may only be able to attract a physician if they can
price discriminate, charge higher prices to higher income patients.

Price discrimination is so common, is it really a "special" case?


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

MGT 551: BUSINESS ECONOMICS CH – 22                                              Professor Mark J. Perry
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."

Updated: December 2, 2011

MGT 551: BUSINESS ECONOMICS CH – 22                                             Professor Mark J. Perry

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