Profit-maximizing entrepreneurial firms.

Firms can have many goals and be organized in a variety of ways. For perfect competition to exist, firms' goals must be profit and only profit, and the people who make the decisions must receive only profits and no other form of income from the firms.

 

Imperfect Competition

Imperfect competition exists when more than one seller competes for sales with other sellers of similar products, each of whom has some control over price. Individual sellers in such markets have a degree of monopoly power, which means they can influence on the price of their product by controlling its availability to buyers. Firms can control prices by differentiating their products either by quality or by brand.

For example, loyal buyers of Coca-Cola, Bayer aspirin gladly pay higher prices for these products than they would for generic ones. In other markets, firms control price by gaming large market shares. We will first discuss imperfectly competitive markets in which sellers gain monopoly power by differentiating their products from those of their competitors.

Monopolistic Competition

Monopolistic competition exists when many sellers compete to sell a differentiated product in a market into which the entry of new sellers is possible. In a monopolistically competitive market:

1. There are relatively large numbers of firms, each satisfying a small, but not microscopic, share of the market demand for a similar, but not identical product. The market share of each rival firm is generally larger than it would have under perfect competition, but it's unlikely that any one firm satisfies not more than 10 percent of market demand.

2. The product of each firm is not a perfect substitute for the products of competing firms. Each seller's product has unique qualities or characteristics that cause some buyers to prefer it to products of competing firms. The product is therefore differentiated from any other product.

For example, people who believe that Reeboks are more comfortable than other sports shoes will pay higher prices for Reeboks than for another shoes. Similarly, people who like the cut or fabrics of Calvin Klein's clothes will pay more for them. Although each seller's product is unique, there's enough similarity among particular kinds of products to group sellers into broad categories. A product group represents several closely related, but not identical, items that serve the same general purpose for consumers. The sellers in each product group can be considered competing firms within an industry.

Arbitrary decisions are necessary to define a product group. Is the footwear industry, for example, to include all types of footwear including men’s shoes, women’s shoes, children's shoes, boots, athletic shoes, and rubber overshoes? Are the providers of fast-food services like McDonald's to be considered members of the restaurant-services product group? The answer isn't clear. Many buyers don't think the meals served by these firms are good substitutes for meals in a full service-restaurant.

3. Firms in an industry don't consider the reaction of their rivals when choosing their product prices or annual sales targets. Because there are a relatively large number of firms in a monopolistically competitive industry, a firm's managers believe that their actions can't significantly reduce the market share of their rivals.

If a single firm cuts the price of its shoes by 20 percent to gain more sales, other firms may experience only a small decrease in sales and are therefore unlikely to react by cutting their prices also. The managers of the first firm know this, so they don't bother to consider any possible reaction from competitors.

4. Relative freedom of entry and exit by new firms exists in monopolistically competitive markets. It's easy to set up new firms in monopolistically competitive markets. Entry may not be quite as easy as it is in perfect competition because new firm with new brands or product features may initially have difficulty establishing their reputations. Existing firms with established brands and reputations for service are likely to hold some competitive edge over new entrants.

Free entry means that profitable conditions in the industry are likely to attract new sellers. In the long run the magnet of profits will serve to increase supplies of the product sold by the industry. This in turn will put downward pressure on both price and profits.

5. Neither the opportunity nor the incentive exists for firms in the industry to cooperate in ways that decrease competition. The firms in a monopolistically competitive market don't cooperate to fix prices in order to increase their group profits. They can't effectively prevent new entrants from responding to profit opportunities by opening rival enterprises.

Product Differentiation

Product differentiation is crucial to monopolistic competition. In fact, product differentiation is really what stands between perfect competition and the real world. People differentiate among many similar products.

What makes one good or service differ from another? We need only for the buyer to believe it's different, because product differentiation takes place in the buyer's mind. In the real world, however, buyers generally do differentiate. We're always differentiating, and it doesn't have to be based on taste, smell, size, or even any physical differences among the products.

Example: Two record shops might carry the same poor excuse that passes for music these days — it can only be played loud, so those young people suffering from hearing loss can still pick up some of the sounds. Both shops charge exactly the same prices. Both shops are conveniently located. But one is always crowded and the other is always empty.

Perhaps one place lets you play a CD before you buy it. Perhaps one place will take special orders for you. Perhaps the sales clerks and owner is nice, helpful people, while in the other store, they're all grouches.

Now we're dealing with a differentiated product. The CDs are the same. The prices are the same. But one store's got ambience up to here, and the other has to send out for it. The buyer prefers Mr. Nice Guy's store over the grouch's store, so we have a differentiated product.

When sellers try to get buyers to differentiate between their products and those of competitors, the sellers do so based on not just physical differences between their product and those of the competitors. Also used are convenience, ambience, reputation of the seller, and appeals to your vanity, unconscious fears, and desires, as well as snob appeal.

Price Discrimination

Price discrimination occurs when a seller charges two or more prices for the same good or service.

Examples:

1. Doctors often charge rich patients 10 times as much for the same service as poor patients.

2. Airlines sometimes allow riders under 16 years of age to fly at half-fare ("youthfare").

3. The most notorious example of price discrimination was probably that of A&P during the 1940s. A&P had three grades of canned goods: A, B, and C. Grade A was presumably of the highest quality, B was fairly good, and C was— well, C was edible. My mother told me that she always bought grade A, even though it was the most expensive. Nothing but the best for our family. Our family was friendly with another family in the neighborhood. The husband, a man in his early 50s, found out he had stomach cancer. "Aha!" exclaimed my mother, "Mrs. S. always bought grade C!"

A few years later the Federal Trade Commission (FTC) prohibited A&P from selling grades A, B, and C. The FTC didn't do that because of Mr. S.'s stomach cancer, but because there was absolutely no difference among the grades.

Why had A&P concocted this elaborate subterfuge? Because it was worth tens of millions of dollars in profits! Take a can of green peas that had a demand schedule like the one in Table 1.

To keep things simple, suppose A&P had a constant ATC of 20 cents a can. How much should it charge? To figure this out, add a total cost column to Table 1 and then a total profits column. Now figure out the total profits at prices of 50 cents, 40 cents, and 30 cents, respectively.

In Table 2, these calculations are all worked out. If A&P could charge only one price, it would be 50 cents; total profit would be $30. Now let's see how much profit would be if A&P were able to charge three different prices.

Table 1

Hypothetical Demand Schedule for Canned Peas

Price	Quantity Demanded	Total Revenue
$ 0.50	100	$50
0.40	140	56
0.30	170	51

At 50 cents, A&P would be able to sell 100 cans. These are sold to the people who won't buy anything if it isn't grade A. Then there are those who would like to buy grade A but just can't afford it. These people buy 40 cans of grade B. Finally, we have the poor, who can afford only grade C; they buy 30 cans.

Table 2

Hypothetical Demand Schedule for Canned Peas

Price	Total Revenue	Total Cost	Total Profit
$ 0.50	$50	$20	$30
0.40	56	28	28
0.30	51	34	17

All this is worked out in Table 3. Total revenue now is $75 for the 170 cans sold, and total cost of 170 cans remains $34. This gives A&P a total profit of $41.

Table 3

Hypothetical Demand Schedule for Canned Peas, by Grades

Grade	Price	Quantity Demanded	Total Revenue	Total Costs	Total Profit
A	$ 0.50	100	$50	$20	$30
B	0.40	40	16	8	28
C	0.30	30	9	6	17
Sum			$75	$34	$41

 

Why is total profit so much greater under price discrimination ($41) than it is under a single price ($30)? Total profit would be $30 at 50 cents; it would be $28 at 40 cents; it would be $17 at 30cents. People are willing to buy only 100 cans at 50 cents, 40 more at 40 cents, and another 30 at 30 cents. But the people who buy only grade A will buy all their cans of green peas at that price, while those buying grade B will buy all their peas at 40 cents and grade C buyers will buy all their peas at 30 cents. By keeping its markets separate rather than charging a single price, A&P had been able to make much larger profits.

The firm that practices price discrimination needs to be able to distinguish between two or more separate groups of buyers.

In addition to distinguishing among separate groups of buyers, the price discriminator must be able to prevent buyers from reselling the product (i.e., stop those who buy at a low price from selling to those who would otherwise buy at a higher price).

If the 15-and-a-half-year-old buys an airline ticket at half-fare and resells it to someone 35 years old, the airline loses money. Most 15-and-a-half-year-olds don't have too much money, so that's a way of filling an otherwise empty seat; but when the 35-year-old flies half-fare and would have been willing to pay full fare, the airline loses money. In the case of A&P. there was no problem preventing the grade C customers from reselling their food to the grade A customers because these people voluntarily separated themselves into these markets.

Price discrimination is woven into our economic fabric, and in most cases it is basically a mechanism for rationing scarce goods and services. For example, since nearly everyone seems to want to go to the movies at 8:00 on Saturday night, the theaters encourage moviegoers to see films at other times by charging considerably less. But the main motivation for price discrimination is, of course, to raise profits. If price discrimination were carried to its logical conclusion, we would have perfect price discrimination.