Consequences of Competition for the Pricing and Output Decisions of Firms

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The consequences of competition for the pricing and output decisions of firms are most easily established in the model of pure competition,1 which requires that            
1.  Potential buyers and sellers are numerous and each is so small relative to the market that individual decisions about purchases or output do not noticeably affect market demand or supply, nor, consequently, do individual decisions affect the market price.  

2.  Firms in the industry produce a homogeneous (standardized) good.  
3.  Barriers to entry or exit are insignificant in the long run; new firms are free to enter the industry if doing so appears profitable or exit if they anticipate losses.  
Generic office supplies, most agricultural products, and a few other relatively homogeneous goods are produced in highly competitive markets. Each buyer or seller is too insignificant to single-handedly affect the total demand or supply of the good, leaving competitive buyers and sellers as quantity adjusting price takers; they have no choice but to accept the price set in the market. Price takers are buyers or sellers who are so small relative to a market that the effects of their transactions are inconsequential for market prices. Thus, individual competitive buyers view the supply curves facing them as perfectly elastic (horizontal) at the current market price. Similarly, competitive sellers perceive the demand curves they face as horizontal at the market price.  

Rivalry?
Competition usually connotes rivalry. We all grow up competing for grades, merit badges, positions on teams, and dates. Iowa farmers broadly compete with other farmers from all around the globe. How are prices set for their corn, wheat, or pigs? Do farmers argue that their products are superior and so should command a premium price? Clearly not. Nor do they offer coupons or instant winner bingo to compete for buyers.  

Competitive price setting occurs for basic farm products (from eggs to sugar to orange juice concentrate), raw materials (coal or crude oil), primary products (steel or lumber), and precious metals (gold or silver) roughly 240 business days each year at commodity exchanges in major cities around the globe.2 Market prices are set for hundreds of commodities in an auction environment by the bids and offers of thousands of buyers and sellers or their broker representatives.  

Commodity exchanges seem chaotic to visitors. Commodities are traded in a climate approaching pure competition, primarily by public outcry. Wild-eyed traders angle various numbers of fingers overhead and scream bids and offers on a huge, crowded trading floor. The din rivals that during the opening kickoff at the Super Bowl. No single buyer or seller can sway prices as bids and offers are accepted or rejected. A trader may buy cotton for a Tokyo customer one minute and sell Georgia peanuts the next, but most traders are narrowly specialized. Small farmers often sell their entire crop at the going market price in a single transaction. Farmers are examples of price takers.  

If you struck gold at your sand-and-gravel site, you could sell all the gold you mined at the going market price ($600), as shown in Figure 1. The demand curve facing each purely competitive mine is a horizontal line (d) at the market price (Pe = $600). Trying to charge a price above Pe would result in no sales, while cutting price below Pe would not increase the ability to sell gold: all your output can be sold at the going price. Thus, purely competitive firms decide what amounts of output to produce and sell at current prices. Even firms mining hundreds of claims using millions of dollars worth of equipment can sell gold only at the going price. This is why pure competitors, including farmers, are price takers.  

Purely competitive firms compete in one dimension: technically efficient production. They try to minimize costs while producing the level of output that maximizes profit. We will present some recipes that a...
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