The quest for profit in a perfectly competitive market.

The assumption that people engage in productive activity in order to make a profit does not apply to everyone all the time. However it does apply to most of us, most of the time. We undertake to referee the local youth soccer league, or to work on a habitat for humanity home with little or no expectation of tangible reward. On the other hand, most of us do not open new businesses, or go to work on a daily basis with little or no consideration of our pay. It is in these for-pay activities that this chapter finds its place.

In the special case of those industries that are peopled by many producers and many buyers, have free entry and exit to and from the industry, and have small start-up costs and well-known production methods – in other words, perfectly competitive industries, the interplay of profit and firm behavior is particularly interesting. If there truly is free and easy entry to the industry the existence of economic profit will attract new entrants. Conversely, if walking away form the industry is fairly costless, economic losses will drive people away from this industry and into another.

Not very many industries fit these conditions. The one most often used in textbooks is the grain segment of the agriculture industry. In the case of your text the example is the corn market – in the one I studied from it was the wheat market. There seems to be an industry that is undergoing great change at the moment; moving from an oligopoly toward a competitive market structure.

The music recording industry has been dominated for many years by a few firms and a strictly controlled marketing structure. In the past few years, however, with the advent of internet sales and inexpensive digital recording capability, the number of recording labels has grown tremendously. It seems that anyone with a spare room available and a very few thousand dollars to start can open a recording studio and begin producing and selling CDs online. Eventually this approach may begin to dominate the recording industry, making it very nearly perfectly competitive. A quick search of the internet turned up over 200 labels devoted to classical music alone and over 400 devoted to various stripes of rock.

Exploration: Exploring the increase of internet and inexpensive recording on the profitability of the recording industry.

This exercise is based on the material in your text beginning on page 198. Look over the graphs above and compare them to Figure 8.2 in your text. In this type of market a shift in demand will result in economic profits or losses being garnered by the individual firms in the industry. Try moving the Dmkt slider to the right (an increase in demand) and observe that the market price rises, generating economic profit to the firm; indicated by the green rectangle in the right-hand graph. It is this available profit that attracts new firms into the industry.

In this exercise the cost functions will remain constant and are presumed to be at the level associated with current inexpensive digital recording. In addition, keep in mind that this deals with recording and selling CDs online, not with peer-to-peer music exchanges such as Kazaa, WinMX, Zeropaid, or Scour.

1. As more individuals become comfortable with buying CDs over the internet how will the price of CDs change in the short run?
   
   
2. How will the result found in question 1 affect the industry and the market price in the longer run?
   
   
3. How might the existence of peer-to-peer music sources affect the CD online industry in the short run?
   
   
4. How will the existence of peer-to-peer music sources affect the CD online industry in the long run?
   
   

Exploration: How can the individual firm break out of the "zero economic profit" long run?

Looking at the decisions available to the individual firm it seems from the questions above that the only choices are to produce or not produce. Of course they have another choice between these two - to increase or decrease the amount they produce.

In this exploration we will be using the Quantity slider (Qfirm) in the right-hand graph as well as the Dmkt adjustment on the left.

1. Why doesn't the individual firm simply increase production and make more money?
   
   
2. If increasing production is not the answer, why not simply cut back and make more money?
   
   
3. Recalling question 1 above, "As more individuals become comfortable with buying CDs over the internet how will the price of CDs change in the short run?", how should we expect the individual firm to respond to the increased industry demand?
   
   
4. In the long run, how will the individual firms respond to an increase in industry demand?
   
   

View Answers

Exercise picked up from the 2e Microeconomics textbook.