could not be correct in their analysis. But as it happens both were right! This happened because each firm used a different measure of market share. Boeing, the older firm and once also the dominant firm in the industry, used the number of airplanes delivered as their measure of market share. Airbus, the younger but rapidly growing firm, used the number of airplanes ordered. Using these different measures both firms could claim to be the largest firm.

Concentration and market structure are the key ingredients in market analysis.

6.3.1PERFECT COMPETITION

Assumptions underlying this model are:

•Products are homogeneous – all products are alike and so no perceived differences exist.

•All participants in the market have perfect knowledge – full information on prices, costs and product availability exist.

•There are a large number of buyers and sellers in the market. Each firm provides a fraction of the output of the industry.

•Firms have no control over price and are, therefore, price takers. Each firm’s demand curve is perfectly elastic. At the market price, firms can sell as much output as they like.

•No barriers to entry or exit exist in the market.

Further characteristics of this market structure include:

•Prices are set by market supply and demand. Market demand is a downward sloping relationship, while market supply is upward sloping.

•At the market price, firms earn normal profits in the long run, no opportunities exist to earn supernormal profits in the long run.

•Factors of production are fully mobile and can be easily transferred from one industry or market to another.

•There is efficient use of resources.

How equilibrium emerges in the short run and long run are considered separately below.

Short-run equilibrium

Figure 6.1 presents the short-run equilibrium for the industry in panel A and the firm in panel B. Industry price is determined by the intersection of the demand and supply curves in panel A. At the short-run equilibrium price P one firm in the industry (panel B) can sell as much output as it likes, but will selling nothing either above or below this price. The firm faces a horizontal demand curve at this price. Industry output is Q I, while the firm’s profit-maximizing output Q F is determined by the intersection of its MR and MC curves.

Since there are many firms in this industry, the quantity each firm produces, Q F, is very small relative to the total output of the industry, Q I. In Figure 6.1, the firm is making supernormal profits since the lower section of its AC curves is below the price. With each individual firm in a perfectly competitive industry able to earn only P for its output, P represents a firm’s additional revenue (MR) if it sells extra output. Since the price the firm receives on any unit of its output is P , this price also represents the firm’s average revenue (AR) on each unit of output. With perfectly elastic demand at the price P , marginal revenue and average revenue are all given by P .

At Q F the firm’s supernormal profit per unit is equal to the distance between price and the AC curve. The firm’s total supernormal profits is represented by the dashed area in Figure 6.1 panel B. If the distance between the price and the AC curve at Q F is £2 and the firm produces 1200 units (Q F = 1200), then the total supernormal profits earned by the firm in the short run is £2400. Conversely, if the firm’s AC curve is above price then the firm is losing money and it will only survive in the short run if it can cover its average variable costs. As explained in Chapter 4,

F I G U R E 6 . 1 S H O R T - R U N E Q U I L I B R I U M I N P E R F E C T C O M P E T I T I O N

the critical short-run survival decision for the firm is whether or not it can cover its

average variable costs.

Long-run equilibrium

Logically, the supernormal profits earned in Figure 6.1 will encourage new firms into the industry and result in the supernormal profits declining as firms compete by charging lower prices. Firms will not compete by offering different quality goods, as goods are presumed to be homogeneous. Existing or incumbent firms may wish to take advantage of such profitable opportunities and may also increase their output. The net result is a shift of the industry supply curve to the right as in panel A in Figure 6.2.

A new lower industry price results at P 1. Panel B outlines the effect of this price reduction for the same firm considered in Figure 6.1. The firm’s price and AR fall in response to the corresponding fall in the industry price. This reduction in both industry price and firm’s AR continues until such time as the AR is tangential to the firm’s long-run average cost curve (LRAC). Additional industry supply continues until equilibrium emerges where it is just economically profitable for the firm to stay in business, since it can cover long-run average costs. Were the industry price to fall any further, the firm would be better off exiting the industry in the long run. No further incentive for new firms to enter the industry exists.

No supernormal profits are earned by a firm in a perfectly competitive market in the long run.

F I G U R E 6 . 2 L O N G - R U N E Q U I L I B R I U M F O R T H E

I N D U S T R Y A N D T H E F I R M U N D E R P E R F E C T C O M P E T I T I O N

Output is produced efficiently in a perfectly competitive industry:

•Production occurs at the minimum point of each firm’s average cost curve.

•The price charged to consumers is the minimum price that could be charged while encouraging firms to stay in the industry.

•Economic resources are used to their maximum efficiency by all firms since prices cover marginal costs (this is allocative efficiency).

•Firms earn normal profits but not supernormal profits, so consumer surplus is maximized.

All outcomes indicate the model of perfect competition to be efficient in theory. Of course, very few examples, if any, of perfectly competitive industries exist in today’s business world. Instead economists tend to use the outcomes of the model as benchmarks for comparison across all types of market structure.

6.3.2MONOPOLY

In a monopoly, one firm supplies the entire market. Such cases are quite rare but do exist. In focusing on the model, we can compare and contrast its implications with the perfect competition case.

The assumptions underlying monopoly market structure are:

•There is only one firm in the industry.

•Entry barriers exist to prevent entry by other firms.

•The monopoly firm maximizes its profits.

•The monopoly product has no close substitutes, therefore each monopoly firm has control over price.

In a monopoly, the firm’s demand function and the industry/market demand function are one and the same – a downward sloping demand curve. The monopoly firm sets its price depending on what it considers the market will bear, evident in the demand function for its product, given its costs.

The monopolist has a large degree of market power or control over price.

The firm sets price so as to maximize profits, i.e. sets MC = MR at point X in Figure 6.3, leading to the monopoly price P m and quantity Q m shown. At this price the firm earns supernormal profits because the price is above average cost. The dashed area in Figure 6.3 represents the total amount of supernormal profits

earned by the monopolist. New firms cannot bid these profits down due to barriers to entry in the industry.

If scale economies imply that only one firm could supply efficiently, i.e. at low cost to the market, a natural monopoly exists.

Monopolies sometimes have a different shaped AC curve to that shown in Figure 6.3. This can arise from the existence of substantial economies of scale in the industry (see Figure 4.7 to refresh your memory). Scale economies result in average costs continually falling over large levels of output. This would be the case in, for example, capital-intensive industries such as the rail industry or electricity provision.

Figure 6.4 illustrates the characteristics of the AC curve and equilibrium in such an industry. Here the monopolist’s AC curve is falling over a large range of output