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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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