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Utilizing the attached PDF, answer the following questions that are included in the PDF:Work the following problems in Chapter 7: Technical questions 1, 2, 3, 4, 5, and 6.Work the following problems in Chapter 7: Application questions 2 and 3.Work the following problems in Chapter 8: Technical questions 4 and 8.Work the following problems in Chapter 8: Application questions 2, 3, and 4.
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7
Market Structure: Perfect
Competition
I
n this chapter, we begin our discussion of market structure, or the environment in which firms operate. This discussion integrates demand and
pricing material with production and cost issues (Chapters 3, 4, 5, and 6).
You have learned that there are four major forms of market structure:
perfect competition, monopolistic competition, oligopoly, and monopoly. The
perfectly competitive firm has no market power because it cannot influence
the price of the product. On the other end of the spectrum is the monopoly
firm that has market power because it can use price and other strategies to
earn larger profits that typically persist over longer periods of time. Between
these two benchmarks are the market structures of monopolistic competition
and oligopoly. Firms have varying degrees of market power in these market
structures that combine elements of both competitive and monopoly behavior.
Managers are always trying to devise strategies that will help their firms
gain and maintain market power. If, and how, they can do this depends on the
type of market structure in which their firms operate.
We begin this chapter with a case study that describes the operation of
the potato industry, an industry that contains the essential elements of the
model of perfect competition. We discuss reactions of different potato farmers to changes in industry prices, attempts by potato farmers to coordinate
the amount of potatoes they produce, and legal challenges to this coordinated
activity. We also describe how changes in tastes and preferences and government regulations have influenced the demand for potatoes and the fortunes of
the industry. We then discuss the model of perfect competition in depth. We
end the chapter with a discussion of managerial strategies in several additional
highly competitive industries that shows how firms in all of these industries
attempt to shield themselves from the volatility of the competitive market.
200
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Case for Analysis
Competition and Cooperative Behavior in the Potato Industry
In 1996 there was a major increase in the supply of fresh
potatoes, which drove potato prices from $8 per 100 pounds in
1995 to between $1.50 and $2 per 100 pounds in 1996, a price
that was one-third the cost of production. Based on the substantial profits they had earned with their 1995 crops, farmers
increased production in 1996, resulting in a 48.8-billion-pound
crop, the largest in U.S. history.1
This was typical behavior in the potato industry where individual potato farmers let the market determine the price they
obtained for their crops. High prices caused farmers to overproduce, which drove prices down below the costs of production for many farmers, making the industry unprofitable. Each
farmer typically tried to gain market share under the assumption that other farmers would have a small crop due to weather,
frosts, pests, or some other natural disaster. If growing conditions turned out favorable, the increased supply of potatoes
pushed prices down, causing financial hardship.
Idaho farmers had some competitive advantage in the markets for bagged potatoes in supermarkets and for baked potatoes in restaurants. Their potatoes often sold for a premium
price of $2 or more per 100 pounds as a result of brand name
recognition. Thus, Idaho producers gained some market power
in these segments by turning an undifferentiated product into
an identifiable brand.2
In September 2004, Idaho potato farmers formed a cooperative, United Potato Farmers of America, to help manage
supply in the potato industry to keep prices high and increase
profits.3 The group expanded nationally and recruited farmers
from California, Oregon, Wisconsin, Colorado, Washington,
and Texas. In 2005 United Potato helped take 6.8 million hundred-pound potato sacks off the U.S. and Canadian markets,
which helped increase open-market returns 48.5 percent from
the previous year. Each year United Potato’s board of directors
would meet before planting season to decide whether farmers were on track to overproduce and to set a target for acreage reduction based on reports from the field and input from
analysts. The cooperative was successful in its first years of
operation. However, some growers expressed concern about
whether the cooperative could maintain its control over supply
and whether most of the benefits of the organization flowed
1
Stephen Stuebner, “Anxious Days in Potatoland: Competitive
Forces Threaten to Knock Idaho from Top,” New York Times,
April 12, 1997.
2
Stuebner, “Anxious Days in Potatoland.”
3
Timothy W. Martin, “This Spud’s Not for You,” Wall Street
Journal (Online), September 26, 2006.
only to Idaho producers. Potato growers serve different customers. French fry producers typically have contracts with
food companies that set production levels and prices, whereas
many other farmers sell their product on the open market.
United Potato argued that its behavior was legal under
the Capper-Volstead Act that exempted farmers from federal
antitrust laws and permitted them to share prices and control
supply. However, in 2010 plaintiffs representing consumers who bought fresh or processed potatoes filed suit against
United Potato and other cooperatives charging that they violated the Capper-Volstead Act by operating as a price-fixing
trade group rather than a legitimate cooperative.4 The plaintiffs
wanted compensatory and punitive damages, court costs, and
a court order for defendants to surrender profits that resulted
from their illegal conduct. In December 2011, a federal judge
denied a motion to dismiss the antitrust conspiracy claims even
though the cooperatives continued to argue that their behavior was permissible under the Capper-Volstead Act. The court
issued an advisory opinion that the Capper-Volstead Act permitted concerted action after production but not coordinated
action that reduced acreage for planting before production.
There have also been changes in the demand for potatoes that have caused problems for potato farmers. The U.S.
Department of Agriculture reported that, after a decade of
phenomenal growth, U.S. consumption of french fries was
expected to decrease 1 percent in the fiscal year ending June
30, 2002.5 Most of this decrease was anticipated to result from
slower expansion of the fast-food industry due to market saturation and increased numbers of outlets, such as Subway restaurants, that do not sell french fries.
U.S. exports of fries have also slowed, given a saturated
Japanese market and the difficulties U.S. firms face in entering
the Chinese market. The U.S. Department of Agriculture has
also developed a fry made from a rice flour mixture that absorbs
30 percent less oil when cooked and could become a substantial
competitor to the traditional french fry in the future. Although
the french-fry industry has fought back by introducing new
4
Brad Carlson, “Federal Lawsuit Alleges Potato Price-Fixing:
Idaho Federal District Court Hears Round of Claims to Dismiss,”
The Idaho Business Review (Online), June 20, 2011; Gregory
E. Heltzer and Nicole Castle, “Potato Price-Fixing Case Survives
Motion to Dismiss Holds That Pre-Production Agricultural
Output Restrictions Are Not Exempt Under Capper-Volstead,”
Antitrust Alert, December 8, 2011.
5
This discussion is based on Jill Carroll and Shirley Leung,
“U.S. Consumption of French Fries Is Sliding As Diners Opt for
Healthy,” Wall Street Journal, February 20, 2002.
201
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PART 1 Microeconomic Analysis
products, including blue, chocolate, and cinnamon-and-sugar
french fries, there are still severe consequences for potato producers from the decreased fry consumption.
Potato farmers and potato prices have also been affected by
changes in consumers’ eating habits, including the popularity
of the low-carbohydrate Atkins diet. It has been estimated that
consumption of fresh potatoes per head is 40 percent below
the level of 40 years ago because Americans do less cooking
at home.6 In 2011, a Harvard nutrition study concluded that a
four-year weight gain among the survey participants was most
strongly associated with potato chips, followed by potatoes,
sugared drinks, unprocessed red meats, and processed meats.
Industry spokesmen indicated that this study might have an
impact similar to that of the Atkins diet.7
There was also a controversy in 2011 when the U.S.
Department of Agriculture (USDA) proposed to eliminate
white potatoes from federally subsidized school breakfasts
and to limit them sharply at lunch.8 In response, the National
Potato Council urged the entire potato industry to mobilize.
After intense lobbying, the U.S. Senate in the November
2011 agricultural funding bill added language blocking the
USDA from limiting potatoes and gave the agency flexibility to regulate the preparation of potatoes in its final version of school nutrition guidelines. Members of the potato
industry and their Congressional supporters were still concerned that the potato was being slighted compared with
other vegetables.
8
6
“United States: Pass the Spuds: The Potato Industry,” The
Economist 378 (March 25, 2006): 62.
7
Brad Carlson, “Idaho Potato Industry Hit by Harvard Nutrition
Study,” The Idaho Business Review (Online), July 1, 2011.
Jennifer Levitz and Betsy McKay, “Spuds, on the Verge of
Being Expelled, Start a Food Fight in the Cafeteria,” Wall
Street Journal (Online), May 17, 2011; Jen Lynds, “Lawmakers,
Industry Decry ‘Backdoor Approach’ to Limiting Potatoes in
Schools,” Bangor Daily News (Online), January 26, 2012.
The Model of Perfect Competition
The description of the potato industry in the chapter’s opening case shows that this
industry closely approximates a perfectly competitive industry. The actual model
of perfect competition is hypothetical. Although no industry meets all the characteristics described here, the industries discussed in this chapter come close on
many of them.
Characteristics of the Model of Perfect Competition
Perfect competition
A market structure characterized
by a large number of firms in
the market, an undifferentiated
product, ease of entry into the
market, and complete information
available to all market participants.
Price-taker
A characteristic of a perfectly
competitive market in which the
firm cannot influence the price of
its product, but can sell any amount
of its output at the price established
by the market.
M07_FARN0095_03_GE_C07.INDD 202
As shown in Table 7.1, perfect competition is a market structure characterized by
1.
2.
3.
4.
A large number of firms in the market
An undifferentiated product
Ease of entry into the market or no barriers to entry
Complete information available to all market participants
In perfect competition, we distinguish between the behavior of an individual
firm and the outcomes for the entire market or industry. The opening case discussed both the production decisions of individual farmers and the outcomes for
the entire potato industry. The model of perfect competition is characterized by
having so many firms in the industry that no single firm has any influence on the
price of the product. Farmers make their own independent planting decisions and
take the price that is established in the market by the overall forces of demand
and supply. Because each farmer’s individual output is small relative to the entire
market, individual producers are price-takers who cannot influence the price of
the product.
In a perfectly competitive market, products are undifferentiated. This market characteristic means that consumers do not care about the identity of the
specific supplier of the product they purchase. Their purchase decision is
based on price. In the potato industry, this characteristic holds in the frenchfry market, where processors do not differentiate among the suppliers of
potatoes except in terms of transportation costs. The case noted that this
13/08/14 1:36 PM
CHAPTER 7 Market Structure: Perfect Competition
TABLE 7.1
203
Market Structure
PERFECT
COMPETITION
MONOPOLISTIC
COMPETITION
OLIGOPOLY
MONOPOLY
Number of firms
competing with
each other
Large number
Large number
Small number
Single firm
Nature of the
product
Undifferentiated
Differentiated
Undifferentiated or
differentiated
Unique differentiated
product with no close
substitutes
Entry into the
market
No barriers to entry
Few barriers to entry
Many barriers to entry
Many barriers to entry,
often including legal
restrictions
Availability of
information to
market participants
Complete information
available
Relatively good
information available
Information likely to be
protected by patents,
copyrights, and trade
secrets
Information likely to be
protected by patents,
copyrights, and trade
secrets
Firm’s control
over price
None
Some
Some, but limited by
interdependent behavior
Substantial
CHARACTERISTIC
characteristic does not hold in the markets for restaurant baked potatoes
and bagged potatoes, where the Idaho brand name carries a premium
price.
The third characteristic of the perfectly competitive model is that entry into the
industry by other firms is costless or that there are no barriers to entry. This characteristic is reasonably accurate in the potato industry, as the number of producers
has increased around the world to satisfy the demands of french-fry processing
plants in different countries.
The final characteristic of the perfectly competitive model is that complete
information is available to all market participants. This means that all participants know which firms are earning the greatest profits and how they are doing
so. Although this issue is not explicitly discussed in the opening case, it appears
that information on the technology of growing potatoes is widespread and can
be easily transferred around the world. Individual farmers typically have a good
understanding of the costs of production and the relationship between prices and
costs in the industry.
Model of the Industry or Market and the Firm
Let’s examine the impact of these characteristics in the model of the perfectly competitive industry or market in Figure 7.1a and the individual firm
in Figure 7.1b. Figure 7.1a presents the model of demand and supply that
we have introduced (Chapter 2). The industry or market demand curve is a
downward sloping demand curve showing the relationship between price and
quantity demanded by the consumers in the market, holding all other factors
constant. The industry supply curve shows the relationship between the price
of the good and the quantity producers are willing to supply, all else held constant.
We now add a description of the individual firm in perfect competition to this
model (see Figure 7.1b). Note first that the demand curve facing the individual firm
is horizontal. The individual firm in perfect competition is a price-taker. It takes
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204
PART 1 Microeconomic Analysis
FIGURE 7.1
$
P
The Model of Perfect Competition
The perfectly competitive firm takes
the equilibrium price set by the
market and maximizes profit by
producing where price, which also
equals marginal revenue, is equal
to marginal cost. The level of profit
earned depends on the relationship
between price and average total cost.
MC
S
ATC
PE
A
B
D = P = MR
D
0
QE
Q
(a) The Perfectly Competitive
Industry or Market.
0
Q1
Q* Q2
Q
(b) The Perfectly Competitive
Individual Firm.
the price established in the market and must then decide what quantity of output
to produce. Because the firm cannot affect the price of the product, it faces a perfectly or infinitely elastic demand curve for its product.
Profit maximization
The assumed goal of firms, which
is to develop strategies to earn the
largest amount of profit possible.
This can be accomplished by
focusing on revenues or costs or
both factors.
Determining the Profit-Maximizing Level of Output How much output
will this individual firm want to produce? The answer to that question depends
on the goal of the firm, which we assume is profit maximization, or earning the largest amount of profit possible. Our definition of profit is given in
Equation 7.1.
7.1
p = TR − TC
where
p = profit
TR = total revenue
TC = total cost
Profit-maximizing rule
To maximize profits, a firm should
produce the level of output where
marginal revenue equals marginal
cost.
Profit is the difference between the total revenue the firm receives from selling
its output and the total cost of producing that output. Because both total revenue
and total cost vary with the level of output produced, profit also varies with output.
Given the goal of profit maximization, the firm will find and produce that level of
output at which profit is the maximum.9
To do so, the firm should follow the profit-maximizing rule, given in Equation 7.2.
7.2
Produce that level of output where MR = MC
where
MR = marginal revenue = ∆TR/∆Q
MC = marginal cost = ∆TC/∆Q
9
Various organizations may pursue other goals. Niskanen (1971) proposed the goal of budget maximization
for government bureaucracies. In this environment, managers receive rewards for the size of the
bureaucracies they control, even if some employees are redundant. Newhouse (1970) and Weisbrod
(1988) also proposed alternative goals for nonprofit organizations. Even profit-maximizing firms may not
always choose the levels of inputs and output that maximize profits in the short run. There may also be
the principal-agent problem where profit maximization might be the goal of a firm’s shareholders but not
necessarily of the managers or agents they hire to run the firm. See William A. Niskanen, Bureaucracy and
Representative Government (Chicago: Aldine-Atherton, 1971); Joseph Newhouse, “Toward a Theory of
Nonprofit Institutions: An Economic Model of a Hospital,” American Economic Review 60 (March 1970):
64–74; Burton A. Weisbrod, The Nonprofit Economy (Cambridge, MA: Harvard University Press, 1988);
and Paul Milgrom and John Roberts, Economics, Organization, and Management (Englewood Cliffs, NJ:
Prentice-Hall, 1992).
M07_FARN0095_03_GE_C07.INDD 204
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CHAPTER 7 Market Structure: Perfect Competition
Marginal revenue is the additional revenue earned by selling an additional unit of
output, while marginal cost is the additional cost of producing an additional unit of
output. If a firm produces the level of output at which marginal revenue equals marginal cost, it will earn a larger profit than by producing any other amount of output.
Although we can derive this rule mathematically,10 Figure 7.1b presents an intuitive explanation for why output level Q*, where marginal revenue equals marginal
cost, maximizes profit for the perfectly competitive firm. In Figure 7.1b, we have
drawn a short-run marginal cost curve, which has a long upward sloping portion
due to the law of diminishing returns in production.
We have discussed the relationship between demand and marginal revenue for
a firm facing a downward sloping demand curve (Chapter 3). The demand curve
showing price was always greater than marginal revenue for all positive levels of
output. However, the perfectly competitive firm faces a horizontal or perfectly elastic demand curve. In this case, and only in this case, the demand curve, which
shows the price of the product, is also the firm’s marginal revenue curve.
Price equals marginal revenue for the perfectly competitive firm because the
firm cannot lower the price to sell more units of output, given that it cannot influence
price in the market. If the price of the product is $20, the firm can sell the first unit of
output at $20. The marginal revenue, or the additional revenue that the firm takes in
from selling this first unit of output, is $20. The firm can then sell the next …
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