978-1118808948 Chapter 7 Lecture Note

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CHAPTER SEVEN

PERFECT COMPETITION

OBJECTIVES

1. To examine supply and demand under perfect competition. (The Basics

of Supply and Demand)

2. To examine equilibrium in the short run and long run and the dynamics of

entry and exit. (Competitive Equilibrium)

3. To study the efficiency of perfectly competitive markets. (Market

Efficiency)

4. To examine issues in global competition and trade. (International Trade)

TEACHING SUGGESTIONS

I. Introduction and Motivation

The present chapter is an introduction to perfect competition. Subsequent

chapters consider monopoly and oligopoly. Thus, this is only the beginning

of the inquiry into market structure. Students should be told to be on the

lookout for how market structure might affect managerial decision making.

The introduction of perfect competition will establish a benchmark against

which other market structures can be compared.

II. Teaching the “Nuts and Bolts”

We begin by discussing with students their notions of competition. In

particular, we discuss the consequences of raising price. In competitive

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markets the comment that “a rise in price will result in customers buying

from a competitor” can lead to a nice discussion about what this comment

assumes about search costs and information, substitutability of products,

number of competitors, etc.

It is reassuring to students to remind them that the principles of managerial

decision making that they have already learned continue to be applicable

given different market structures. In fact, they may be well served by

reviewing Chapter 2 (Optimal Decisions Using Marginal Analysis). The only

difference, in terms of optimization, is the specification of the demand curve.

In perfect competition it is horizontal. In a pure monopoly (Chapter 8), the

single firm faces a downward-sloping industry demand curve.

It is worth spending some time on long-run equilibrium because it gives the

students a feeling for the dynamics of entry and exit and about how markets

evolve. You may want to refer back to Chapter 6’s discussion of economic

profits and to emphasize that zero economic profit includes a normal rate of

return on invested capital.

Finally, the instructor should spend some time explaining and illustrating the

efficiency implications of perfectly competitive markets. Again, one should

caution students that not all markets are perfectly competitive. Nonetheless,

studying perfectly competitive markets establishes a bench-mark and helps

to identify sources of market failure.

III. Discussion Assignment

The “southwest water shortage” reproduced on page 4 makes for an

interesting discussion vehicle. The instructor should distribute the page to

students and can then pose the following questions:

– Is there a water shortage? What are the signs?

– What is the cause of the shortage?

– Is there currently a free market for buying and selling water?

– What are the potential advantages of such a market (if it were created)?

What are the potential disadvantages?

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Suggested answers: The absence of a market for freely buying and selling

water is at the heart of the seeming paradox of “waste amid shortage” in the

Southwest. Presently opportunities to buy and sell water are limited and

occur at wildly different prices. Farmers have historic rights to buy, but not

sell, water at very low prices, while some users, such as chemical

companies, cannot buy water at any price. Because many users pay a price

well below the resource’s replacement cost, the signs of waste and inefficient

use — open-ditch irrigation, cultivation of water-intensive, low-value crops —

are hardly surprising. A first step toward a more rational program of water

use would be for the government to end its subsidy programs and raise the

prices it charges farmers for water. Higher prices would bring forth the

expected economic reaction: water conservation and the withdrawal of

marginal crops. Water waste would be reduced, and a fall in water demand

would alleviate some symptoms of shortage.

The second crucial step is to institute a well-functioning, liquid (pardon the

pun) market for water. Allowing current water recipients to sell their water

would greatly swell and deepen the available water supply to others. (The

small farmer or rancher would find it far more profitable to sell his or her

water than to raise marginal crops or cattle.) This in itself would do more to

eliminate the shortage than any number of costly new water projects. With

buyers and suppliers facing the same market price, water would be directed

to the users to whom it is most valuable. To date, some southwestern states

have attempted to open up limited water markets. This effort has been

strengthened by the end of funding for most new water projects on the

grounds that they are not economic. However, establishing a widespread

water market poses at least two problems, one economic and one political..

The economic problem concerns externalities. Any expected rise in the price

of water increases the incentive to tap rivers and groundwater for a profit.

The result is the destruction of the water table and the salinization of the

region’s major waterways. The political problem is that large windfall profits

and losses accompany higher water prices — profits for those who have

grandfathered water rights and losses for those who no longer receive

subsidized water.

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The Southwest Water Shortage

Water is the lifeblood of the American Southwest. Since the turn of the

century, the growth of the West has depended on water supplied by federal

projects such as dams, canals, and aqueducts. California’s Imperial Valley,

perhaps the richest agricultural area per acre in the world, was created and

continues to depend on transported water. Today the Southwest’s most

valuable resource is being misused and wasted even as experts warn of

impending and chronic water shortages. California’s supply of water is

estimated to fall well short of its need.

The same is true for most other southwestern states. Cities, farms, heavy

industry, mines, electric power stations, and parks and other recreation

facilities all compete for a limited amount of water. Moreover, by law (and

historical accident) these various users pay sharply different prices for

government-supplied water. Los Angeles residents pay in excess of $250 per

acre foot (the quantity of water needed to cover an acre a foot deep),

whereas farmers in many regions pay no more than $10 per acre foot. Many

chemical companies, desperate for water, cannot acquire sufficient amounts

at any price.

Yet there is waste amid shortage. Farmers use open-ditch irrigation methods

and cultivate low-value, water-intensive crops. Homeowners douse their

already emerald lawns with water. Industry fails to take full advantage of

recycling waste water. Swimming pools and golf courses continue to

proliferate. Not surprisingly, water users continue to demand that

government provide an ever-increasing supply of cheap water. In a time of

budget deficits, should the federal government continue to build expensive

new dams, canals, and other water projects and charge the Southwest

subsidized (below full cost) prices for water? Are there better economic

solutions to the region’s dual problems of waste and shortage?

Volatile Oil Prices: 1999-2005

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The six-year period between 1999 and mid-2005 witnessed renewed

volatility in the price of crude oil. Crude oil prices varied from $15 per

barrel at the beginning of the period to over $60 by mid-2005. How do the

basic economic forces of supply and demand explain these dramatic price

fluctuations?

Consider the year 2002 (in the middle of this period) and a time of

relatively stable prices. Strong economic growth in the United States and

Europe and economic recovery in Asia boosted oil demand. At the same

time, the Organization of Petroleum Exporting Countries (OPEC),

comprising about 37 percent of total world supply, held fast to its

production quotas in order to stabilize the average price of crude in the

range of $25 to $28 per barrel. To get a quantitative understanding of the

resulting price effects, consider the following bare-bones demand and

supply model. Let normal worldwide oil demand in 2002 be described by

the equation QD = 90 – .6P, and let normal oil supply be QS = 75 million

barrels per day. Equating demand and supply, QD = QS, implies 90 – .6P =

75, or P = $25 per barrel, a good prediction of the actual price. (In

graphical terms, the downward-sloping demand curve intersects the

vertical supply curve at a price of $25.)

Now backtrack to early 1999. The rock-bottom average crude prices at

the beginning of that year stemmed from a combination of ample supplies

and depressed demand. The aftermath of the 1998 economic slowdown in

East Asia (the financial crisis and Japan’s continued recession) contributed

to reduced overall demand. At the same time, OPEC was providing ample

oil supplies (members were overproducing their supply quotas) and

Western producers were also awash in oil. As an illustration, 1999 supply

was about 76 million barrels per day, and 1999 demand was 5 million

barrels per day less than in 2002, implying the demand equation QD = 85 – .

6P. Now setting demand equal to supply implies a $15 per barrel

equilibrium price (again firmly in the range of actual prevailing prices). In

1999, both depressed demand (a leftward shift in the demand curve) and

extra supply (a slight rightward shift in the supply curve) combined to

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cause a large drop in price relative to the normal level of $25 per barrel.

(Check this qualitatively by constructing the appropriate graph with

shifting demand and supply curves.)

Finally consider events in 2004. Between 2002 and 2004 demand grew

significantly, implying a new demand curve: QD = 104 – .6P. But in the first

half of 2004, crude supply was about 80 million barrels per day, up only

slightly from the 2002 level. The continuing war in Iraq and oil worker

strikes in Venezuela each cut about 2 million barrels per day of supply.

These cuts were balanced by increased production by Saudi Arabia and

other OPEC and non-OPEC producers. Increased demand and limited

supply meant an oil price surge – namely QD = 104 – .6P = 80, which

implied an actual price, P = $40 per barrel. Oil prices continued to rise

during 2005 fueled by surging demand (particularly from fast-growing

China) and supply disruptions from natural disasters (Hurricane Katrina)

and terrorist threats.

Because the crude oil demand and supply curves are quite inelastic,

relatively small quantity changes can lead to large price fluctuations. It is

easy to check that the 2004 crude oil demand curve is relatively steep. (Plot

the curve for yourself.) Demand is quite price inelastic: EP = (dQ/dP)(P/Q)

= (-.6)(40/80) = -.3, at P = $40 and Q = 80. Furthermore, we have been

dealing with a vertical, perfectly inelastic supply curve. Although supply

might vary little in the very short run (three months), higher prices will

certainly induce some supply increase in the longer run (6 months and

longer). Suppose that the long-run supply response in 2004 is estimated

according to the equation QS = 70 + .4P. (This equation is consistent with

supply behavior under the more stable price experience of 2003: 80 million

barrels supplied at a price of $25 per barrel.) Now, higher prices induce

greater oil supplies; the longer-run supply curve is not vertical.) Setting

2004 demand, QD = 104 – .6P, equal to supply implies 104 – .6P = 70 + .4P,

so that the longer-run equilibrium price is $34 per barrel with a global

output of 83.6 million barrels per day. According to this equilibrium

analysis, the longer-run increase in supply would be expected to bring

prices down from above $40 per barrel to the mid-$30 range.

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ADDITIONAL MATERIALS

I. Short Readings

M. Ridley, “The World’s Resources aren’t Running Out,” The Wall Street

Journal, April 26, 2014, pp. C1, C2.

G. S. Becker and J. J. Ellias, “Cash for Kidneys: The Case for a Market for

Organs,” The Wall Street Journal, January 18, 2014, pp. C1, C2.

A. Lowry, “Is Uber’s Surge-Pricing an Example of High-Tech Gouging?”

The New York Times Magazine, January 12, 2014, pp. 18-20.

J. E. Cohen, “Seven Billion,” The New York Times, October 24, 2011, p.

A19.

W. S. Cohen, “Obama and the Politics of Outsourcing,” The Wall Street

Journal, October 12, 2010, pp. A1, A10.

D. A. Irwin, “Goodbye, Free Trade?” The Wall Street Journal, October 9,

2010, pp. C1, C2.

A. Singhal, “Competition in an Instant,” The Wall Street Journal, September

17, 2010, p. A19.

C. Rule, “Trust Us isn’t an Answer,” The Wall Street Journal, September 17,

2010, p. A19. (This article and the preceding one debate whether Google is

good or bad for competition.)

J. Surowiecki, “The Free-Trade Paradox,” The New Yorker, May 26, 2008, p.

30.

L. Lahart, P. Barta, and A. Batson, “New Limits to Growth Revive Malthusian

Fears,” The Wall Street Journal, March 24, 2008, pp. A1, A12.

J. Diamond, “What’s your Consumption Factor?,” The Wall Street Journal,

January 2, 2008, pp. A19.

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J. Tierney, “The $10,000 Question,” The New York Times, August 23, 2005,

p. A23. (The economics versus ecology bet revisited.)

H. Varian, “Technology Levels the Business Playing Field,” The New York

Times, August 25, 2005, p. C2.

B. Davis, “Finding Lessons of Outsourcing in 4 Historical Tales,” The Wall

Street Journal, March 29, 2004, p. A1.

V. Postrel, “Selection Ranks above Price among the Benefits of Shopping

Online,” The New York Times, April 22, 2004, p. C2.

V. Postrel, “When it Comes to Books, Internet Selling has not Led to

Uniformly Lower Prices,” The New York Times, September 11, 2003, p. C2.

H. R. Varian, “The Usual Decorous Waltz between Prices and Sales

Becomes a Lively Tango in the World of Online Sales,” The New York

Times, December 19, 2002, p. C2.

H. R. Varian, “When Commerce Moves Online, Competition can Work in

Strange Ways,” The New York Times, August 24, 2000, p. 38.

“When the Boomster Slams the Doomster, Bet on a New Wager,” The Wall

Street Journal, June 5, 1995, p. A1.

II. Longer Readings

Paul Sabin, The Bet: Paul Ehrlich, Julian Simon, and Our Gamble over

Earth’s Future, Yale University Press, New Haven, 2013.

P. A. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments

of Mainstream Economists Supporting Globalization,” Journal of Economic

Perspectives, Summer 2004, 135-146.

Brynjolfsson, E., Y. Hu, and M. D. Smith, “Consumer Surplus in the Digital

Economy: Estimating the Value of Increased Product Variety at Online

Booksellers,” Management Science, November 2003, 1580-1596.

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Symposium on E-Commerce, Journal of Economic Perspectives, 15, Winter

2001, 3-80.

P. Evans and T. S. Wurster, “Strategy and the New Economics of

Informa-tion,” Harvard Business Review, September-October 2000, 71-82.

III. Cases

The Aluminum Industry in 1994 (9-799-129), Harvard Business School,

2002. Teaching Note (5-700-014).

The Offshore Drilling Industry (9-799-111), Harvard Business School, 2001.

Teaching Note (5-700-016).

Economic Liberalization and Industry Dynamics (9-700-075), Harvard

Business School, 2000.

IV. Quips and Quotes

You can make even a parrot into a learned political economist – all it must

learn are the two words “supply” and “demand.”

Everything is worth what its purchaser will pay for it. (Publilius Syrus)

A cynic is a man who knows the price of everything and the value of

nothing. (Oscar Wilde)

If competition has its evils, it prevents greater evils . . . (John Stuart Mill)

When the last of the Bourgeoisie are hanged, a capitalist will sell the rope.

The business of America is business. (President Calvin Coolidge)

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