No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Eight: Market Structure: From competition to monopoly 183 When a market has these features, suppliers are unable to exercise market power, (i.e., set a price for their product). The price a supplier receives is therefore always equal to the marginal revenue, as we’ll see later. This model is hard to find in the real world, although commodity markets (such as corn, wheat, aluminum, and other raw materials) are a pretty close match. Product differentiation is certainly more difficult for commodity markets, but not impossible— as the development of organically-grown produce markets attest. Organically-grown produce commands a significant premium over regular produce in most supermarkets. But for the most part, the wheat market is a perfectively competitive market; there are millions of farmers in dozens of countries selling wheat. No individual farmer can try to sell for a higher price because the other farmers have an identical product (a perfect substitute) and all buyers can readily find out the going rate for wheat in global markets. With the exception of differing transportation costs and risks (which ensures they really aren’t perfect substitutes), the products will sell for the same price. In this market, per Figure 8.1 , the market supply and demand curve looks the same as usual (downward- sloping demand and upward-sloping supply); but, the individual farmer faces a horizontal demand curve. Farmer Joe can sell all the wheat he wants at the market price. How does Farmer Joe react to the market price? As we saw in chapter 7, a profit maximizing agent will produce an output level that equates the marginal revenue to the marginal cost. Recall that when we use the term marginal, we simply mean the additional revenue or additional cost from producing one more unit of the given product. In a perfectly competitive market, the marginal revenue is always constant and equal to the price. No matter how many bushels of wheat Farmer Joe sells, by our assumption, he is such a small player in the global wheat market that the price is unaffected by any amount of supply he can bring to the market. Given the global market price that Farmer Joe faces, he will produce five tons of wheat, where his supply curve (his marginal cost curve) equals the marginal revenue he can obtain. Producing at lower output levels would not take advantage of market prices that are greater than his production costs, and producing at a higher level would result in losses, since costs exceed revenues. In the short run, production at MR=MC is the profit maximizing level, but can also be the loss minimizing level. The marginal revenue must cover the variable costs, but not all of the fixed costs, as seen in Figure 8.2 . Given the overall market price which will not change based on his production, Figure 8.2, Profit or Loss? Producing at marginal cost equal to marginal revenue does not ensure a profit, as seen above. If a firm’s fixed costs are high enough, average total costs to produce a product may exceed the average revenue (the price) received, such as with ATC 1 above. The loss would equal the difference between the average price received (the price) and the average total cost, multiplied by the quantity produced, as shown by the “loss” rectangle above. Conversely, if for some reason costs dropped dramatically, such as with ATC 3 above, the entrepreneur will make a profit equal to the size of the “profit” rectangle. In the long run, only the “break even” case of ATC 2 is possible. S=MC Loss ATC 2 ATC 3 D=MR=AR ATC 1 P ($) Q (#) Q* P* Profit