Why does a firm in a perfectly competitive industry charge the market price?
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In this chapter, we have paid a great deal of attention to demand, but we have not spoken of supply. There is a good reason for this: a firm with market power does not have a supply curve. A supply curve for a firm tells us how much output the firm is willing to bring to market at different prices. But a firm with market power looks at the demand curve that it faces and then chooses a point on that curve (a price and a quantity). Price, in this chapter, is something that a firm chooses, not something that it takes as given. What is the connection between our analysis in this chapter and a market supply curve? Show
Perfectly Competitive MarketsIf you produce a good for which there are few close substitutes, you have a great deal of market power. Your demand curve is not very elastic: even if you charge a high price, people will be willing to buy the good. On the other hand, if you are the producer of a good that is very similar to other products on the market, then your demand curve will be very elastic. If you increase your price even a little, the demand for your product will decrease a lot. The extreme case is called a perfectly competitive market. In a perfectly competitive market, there are numerous buyers and sellers of exactly the same good. The standard examples of perfectly competitive markets are those for commodities, such as copper, sugar, wheat, or coffee. One bushel of wheat is the same as another, there are many producers of wheat in the world, and there are many buyers. Markets for financial assets may also be competitive. One euro is a perfect substitute for another, one three-month US treasury bill is a perfect substitute for another, and there are many institutions willing to buy and sell such assets. An individual seller in a competitive market has no control over price. If the seller tries to set a price above the going market price, the quantity demanded falls to zero. However, the seller can sell as much as desired at the market price. When there are many sellers producing the same good, the output of a single seller is tiny relative to the whole market, and so the seller’s supply choices have no effect on the market price. This is what we mean by saying that the seller is “small.” It follows that a seller in a perfectly competitive market faces a demand curve that is a horizontal line at the market price, as shown in Figure 6.20 "The Demand Curve Facing a Firm in a Perfectly Competitive Market". This demand curve is infinitely elastic: −(elasticity of demand) = ∞. Be sure you understand this demand curve. As elsewhere in the chapter, it is the demand faced by an individual firm. In the background, there is a market demand curve that is downward sloping in the usual way; the market demand and market supply curves together determine the market price. But an individual producer does not experience the market demand curve. The producer confronts an infinitely elastic demand for its product. Figure 6.20 The Demand Curve Facing a Firm in a Perfectly Competitive Market The demand curve faced by a firm in a perfectly competitive market is infinitely elastic. Graphically, this means that it is a horizontal line at the market price. Everything we have shown in this chapter applies to a firm facing such a demand curve. The seller still picks the best point on the demand curve. But because the price is the same everywhere on the demand curve, picking the best point means picking the best quantity. To see this, go back to the markup formula. When demand is infinitely elastic, the markup is zero: markup=1−(elasticity of demand)−1=1∞=0,so price equals marginal cost: This makes sense. The ability to set a price above marginal cost comes from market power. If you have no market power, you cannot set a price in excess of marginal cost. A perfectly competitive firm chooses its level of output so that its marginal cost of production equals the market price. We could equally get this conclusion by remembering that marginal revenue = marginal costand that when −(elasticity of demand) is infinite, marginal revenue equals price. If a competitive firm wants to sell one more unit, it does not have to decrease its price to do so. The amount it gets for selling one more unit is therefore the market price of the product, and the condition that marginal revenue equals marginal cost becomes price = marginal cost.For the goods and services that we purchase regularly, there are few markets that are truly perfectly competitive. Often there are many sellers of goods that may be very close substitutes but not absolutely identical. Still, many markets are close to being perfectly competitive, in which case markup is very small and perfect competition is a good approximation. Why does a firm in a competitive industry charge the market price *?Why does a firm in a competitive industry charge the market price? If a firm charges less than the market price, it loses potential revenue. If a firm charges more than the market price, it loses all its customers to other firms. The firm can sell as many units of output as it wants to at the market price.
Why can't a firm in a perfectly competitive industry charge a price above the market price?Radish growers—and perfectly competitive firms in general—have no reason to charge a price lower than the market price. Because buyers have complete information and because we assume each firm's product is identical to that of its rivals, firms are unable to charge a price higher than the market price.
Why are firms in a perfectly competitive market price takers?A perfectly competitive firm is known as a price taker, because the pressure of competing firms forces them to accept the prevailing equilibrium price in the market. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors.
Why does a perfectly competitive firm not charge a price above the market price Why does it not charge a price below the market price?Because the buyers have perfect substitutes of the product at a market price that is lower than the price charged.
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