AE 11 (MANAGERIAL ECONOMICS)

Module 6: Market Equilibrium and the Perfect

Competition Model

Activity Description Time to Complete

1. Formative Resource prices and quantities exchanged are
determined in resource markets. The roles of
Activity producers and consumers are the reverse of
those in the product markets. Otherwise, the 30 Minutes
mechanics of the process are very similar to the
markets for goods and services. Payments to
households for resource services provide
household income. The distribution of income in
the economy is determined by the resource
holdings of each household and the relative
value of the resources. The factor that affect
the supply and demand for resources will also
affect the distribution of income.
Section 1. Resource Markets
a. Demand for Labor: Single Variable
Input
2. Lesson Proper b. Demand for Labor: Multiple Inputs
Section 2. Market Demand for Labor 240 Minutes
a. Supply of Labor
Section 3. Market Equilibrium
Section 4. Elasticity of Substitution and
Income Distribution

Application of knowledge consumer

choice and demand analysis.

3. Summative Reinforcement on Students’ 45 Minutes

Assessment understanding on demand analysis
45 Minutes
4. Reinforcement
Discussion Total: 360 minutes
2021-2022 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
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Overview of Module
In this module, we will focus on what might be considered the gold standard of a
market: the perfect competition model. The operations of actual markets deviate from
the perfect competition model, sometimes substantially. Still, this model serves as both
a good initial framework for describing how a market functions and a reference base for
evaluating any market.
Learning Objectives
Dear students, what will you learn from this module?
At the end of the module, learners are expected to:
 Explain the assumptions of perfect competition.
 Analyze the perfect competition in the long-run.
 Determine supply curves of the firms.
 Explain market equilibrium.
 Illustrate the market equilibrium using graph or diagram.

A. Assumptions of the Perfect Competition Model

The perfect competition model is built on five assumptions:

1. The market consists of many buyers. Any single buyer represents a very small fraction of all
the purchases in a market. Due to its insignificant impact on the market, the buyer acts as a price taker,
meaning the buyer presumes her purchase decision has no impact on the price charged for the good.
The buyer takes the price as given and decides the amount to purchase that best serves the utility of her
household.

2. The market consists of many sellers. Any single seller represents a very small fraction of all the
purchases in a market. Due to its insignificant impact on the market, the seller acts as a price taker,
meaning the seller presumes its production decisions have no impact on the price charged for the good
by other sellers. The seller takes the price as given and decides the amount to produce that will generate
the greatest profit

3. Firms that sell in the market are free to either enter or exit the market. Firms that are not
currently sellers in the market may enter as sellers if they find the market attractive. Firms currently
selling in the market may discontinue participation as sellers if they find the market unattractive. Existing
firms may also continue to participate at different production levels as conditions change.

4. The good sold by all sellers in the market is assumed to be homogeneous. This means every
seller sells the same good, or stated another way, the buyer does not care which seller he uses if all
sellers charge the same price

5. Buyers and sellers in the market are assumed to have perfect information. Producers
understand the production capabilities known to other producers in the market and have immediate

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access to any resources used by other sellers in producing a good. Both buyers and sellers know all the
prices being charged by other sellers.

B. Operation of a Perfectly Competitive Market in the

Short Run
The consequence of the preceding assumptions is that all exchanges in a perfectly competitive
market will quickly converge to a single price. Since the good is viewed as being of identical quality and
utility, regardless of the seller, and the buyers have perfect information about seller prices, if one seller
is charging less than another seller, no buyer will purchase from the higher priced seller. As a result, all
sellers that elect to remain in the market will quickly settle at charging the same price.

In Module 2 "Key Measures and Relationships" and Module 3 "Demand and Pricing", we
examined the demand curves seen by a firm. In the case of the perfect competition model, since sellers
are price takers and their presence in the market is of small consequence, the demand curve they see is
a flat curve, such that they can produce and sell any quantity between zero and their production limit
for the next period, but the price will remain constant (see Figure 6.1 "Flat Demand Curve as Seen by an
Individual Seller in a Perfectly Competitive Market").

It must be noted that although each firm in the market perceives a flat demand curve, the
demand curve representing the behavior of all buyers in the market need not be a flat line. Since some
buyers will value the item more than others and even individual buyers will have decreasing utility for
additional units of the item, the total market demand curve will generally take the shape of a downward
sloping curve, such as Figure 6.2 "Demand Curve as Seen for All Sellers in a Market".

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 The downward sloping nature of the market demand curve in Figure 6.2 "Demand Curve as
Seen for All Sellers in a Market" may seem to contradict the flat demand curve for a single firm depicted
in Figure 6.1 "Flat Demand Curve as Seen by an Individual Seller in a Perfectly Competitive Market".
This difference can be explained by the fact that any single seller is viewed as being a very small
component of the market. Whether a single firm operated at its maximum possible level or dropped out
entirely, the impact on the overall market price or total market quantity would be negligible.

Although all firms will be forced to charge the same price under perfect competition and firms
have perfect information about the production technologies of other firms, firms may not be identical in
the short run. Some may have lower costs or higher capacities. Consequently, not all firms will earn the
same amount of profit.

As described in the description of the shutdown rule in Module 2 "Key Measures and
Relationships", some firms only operate at an economic profit because they have considerable sunk
costs that are not considered in determining whether it is profitable to operate in the short run. Thus,
not only are there differences in profits among firms in the short run, but even if the market price were
to remain the same, not all the firms would be able to justify remaining in the market when their fixed
costs need to be replenished, unless they were able to adapt their production to match the more
successful operators.

C. Perfect Competition in the Long Run

As described in Module 4 "Cost and Production", a long-run time frame for a producer is enough
time for the producer to implement any changes to its processes. In the short run, there may be
differences in size and production processes of the firms selling in the market. Some sellers may be able
to make a healthy economic profit, whereas others may only barely make enough to justify continued
operation and, as noted earlier, may not have sustainable operations although they may continue to
operate for a while since a substantial portion of their short-run costs are sunk costs.
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 Due to the assumption of perfect information, all sellers know the production techniques of
their competitors. As a result, any firm that intends to remain in the market will revise its operations to
mimic the operations of the most successful firms in the market. In theory, in the long run all firms
would either have the most cost-efficient operations or abandon the market.

However, when all firms use the same processes, the possibility for firms to continue to earn
positive economic profits will disappear. Suppose all firms are earning a positive profit at the going
market price. One firm will see the opportunity to drop its price a small amount, still be able to earn an
economic profit, and with the freedom to redefine itself in the long run, no longer be constrained by
short-run production limits. Of course, when one firm succeeds in gaining greater profit by cutting its
prices, the other firms will have no choice but to follow or exit the market, since buyers in perfect
competition will only be willing to purchase the good from the seller who has the lowest price. Since the
price has been lowered, all firms will have a lower economic profit than they had collectively before they
lowered the price.

Some firms may realize they can even drive the price lower, again take sales from their
competitors, and increase economic profit. Once again, all firms will be required to follow their lead or
drop out of the market because firms that do not drop the price again will lose all their customers. And
once again, as all firms match the lowered price, the economic profits are diminished.

In theory, due to competition, homogeneous goods, and perfect information, firms will continue
to match and undercut other firms on the price, until the price drops to the point where all remaining
firms make an economic profit of zero. As we explained earlier, an economic profit of zero is sufficient to
sustain operations, but the firm will no longer be earning an accounting profit beyond the opportunity
costs of the resources employed in their ventures.

Another necessary development in the long run under perfect competition is that all firms will
need to be large enough to reach minimum efficient scale. Recall from Module 4 "Cost and Production"
that minimum efficient scale is the minimum production rate necessary to get the average cost per item
as low as possible. Firms operating at minimum efficient scale could charge a price equal to that
minimum average cost and still be viable. Smaller firms with higher average costs will not be able to
compete because they will have losses if they charge those prices yet will lose customers to the large
firms with lower prices if they do not match their prices. So, in the long run, firms that have operations
smaller than minimum efficient scale will need to either grow to at least minimum efficient scale or
leave the market.

D. Firm Supply Curves and Market Supply Curves

The demand curve describes how either one consumer or a group of consumers would change
the amount they would purchase if the price were to change. Producers may also adjust the amounts
they sell if the market price changes.

Recall from Module 2 "Key Measures and Relationships" the principle that a firm should
operate in the short run if they can achieve an economic profit; otherwise, the firm should shut down in
the short run. If the firm decides it is profitable to operate, another principle from Module 2 "Key
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Measures and Relationships" stated that the firm should increase production up to the level where
marginal cost equals marginal revenue.

In the case of a flat demand curve, the marginal revenue to a firm is equal to the market price.
Based on this principle, we can prescribe the best operating level for the firm in response to the market
price as follows:

• If the price is too low to earn an economic profit at any possible operating
level, shut down.

• If the price is higher than the marginal cost when production is at the
maximum possible level in the short run, the firm should operate at that
maximum level.

• Otherwise, the firm should operate at the level where price is equal to
marginal cost

Figure 6.3 "Relationship of Average Cost Curve, Marginal Cost Curve, and Firm Supply Curve for a
Single Seller in a Perfectly Competitive Market" shows a generic situation with average (economic) cost
and marginal cost curves. Based on the preceding rule, a relationship between the market price and the
optimal quantity supplied is the segment of the marginal cost curve that is above the shutdown price
level and where the marginal cost curve is increasing, up to the point of maximum production. For prices
higher than the marginal cost at maximum production, the firm would operate at maximum production.

This curve segment provides an analogue to the demand curve to describe the best response of
sellers to market prices and is called the firm supply curve. As is done with demand curves, the
convention in economics is to place the quantity on the horizontal axis and price on the vertical axis.
Note that although demand curves are typically downward sloping to reflect that consumers’ utility for a
good diminishes with increased consumption, firm supply curves are generally upward sloping. The
upward sloping character reflects that firms will be willing to increase production in response to a higher
2021-2022 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
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market price because the higher price may make additional production profitable. Due to differences in
capacities and production technologies, seller firms may have different firm supply curves.

If we were to examine all firm supply curves to determine the total quantity that sellers
would provide at any given price and determined the relationship between the total quantity provided
and the market price, the result would be the market supply curve. As with firm supply curves, market
supply curves are generally upward sloping and reflect both the willingness of firms to push production
higher in relation to improved profitability and the willingness of some firms to come out of a short-run
shutdown when the price improves sufficiently.

E. Market Equilibrium
The market demand curve indicates the maximum price that buyers will pay to purchase a given
quantity of the market product. The market supply curve indicates the minimum price that suppliers
would accept to be willing to provide a given supply of the market product. In order to have buyers and
sellers agree on the quantity that would be provided and purchased, the price needs to be a right level.

The market equilibrium is the quantity and associated price at which there is concurrence
between sellers and buyers. If the market demand curve and market supply curve are displayed on the
same graph, the market equilibrium occurs at the point where the two curves intersect (see Figure 6.4
"Market Equilibrium as the Coordinates for Quantity and Price Where the Market Demand Curve
Crosses the Market Supply Curve").

Recall that the perfect competition model assumes all buyers and sellers in the market are price
takers. This raises an interesting question: If all the actors in the market take the price as given
condition, how does the market get to an equilibrium price?

One answer to this question was provided by the person who is often described as the first
economist, Adam Smith. Adam Smith lived in the late 18th century, many years before a formal field of
economics was recognized. In his own time, Smith was probably regarded as a philosopher. He wrote a
treatise called The Wealth of Nations. See Smith (1776). in which he attempted to explain the prosperity
that erupted in Europe as the result of expanded commercial trade and the industrial revolution.

Smith ascribed the mechanism that moves a market to equilibrium as a force he called the
invisible hand. In effect, if the price is not at the equilibrium level, sellers will detect an imbalance
between supply and demand and some will be motivated to test other prices. If existing market price is
below the equilibrium price, the provided supply will be insufficient to meet the demand. Sensing this,
some suppliers will try a slightly higher price and learn that, despite perfect information among buyers,
some buyers will be willing to pay the higher price if an additional amount would be supplied. Other
sellers will see that the higher price has enough demand and raise their prices as well. The new price
may still be below equilibrium, so a few sellers will test a higher price again, and the process will repeat
until there is no longer a perception of excess demand beyond the amount buyers want at the current
price.

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 If the market price is higher than the equilibrium price, sellers will initially respond with
increased rates of production but will realize that buyers are not willing to purchase all the goods
available. Some sellers will consider lowering the price slightly to make a sale of goods that would
otherwise go unsold. Seeing this is successful in encouraging more demand, and due to buyers being
able to shift their consumption to the lower priced sellers, all sellers will be forced to accept the lower
price. As a result, some sellers will produce less based on the change in their firm supply curve and other
sellers may shut down entirely, so the total market supply will contract. This process may be repeated
until the price lowers to the level where the quantity supplied is in equilibrium with the quantity
demanded.

In actual markets, equilibrium is probably more a target toward which prices and market
quantity move rather than a state that is achieved. Further, the equilibrium itself is subject to change
due to events that change the demand behavior of buyers and production economics of suppliers.
Changes in climate, unexpected outages, and accidental events are examples of factors that can alter
the market equilibrium. As a result, the market price and quantity is often in a constant state of flux, due
to both usually being out of equilibrium and trying to reach an equilibrium that is itself a moving target.

F. Shifts in Supply and Demand Curves

In addition to the factors that cause fluctuations in the market equilibrium, some developments
may lead to sustained changes in the market equilibrium. For example, if a new product becomes
available that is a viable substitute for an existing product, there is likely to be either a persistent drop in
the quantity consumed of the existing good or a reduction in the market price for the existing good.

The impact of these persistent changes can be viewed in the context of changes in the behavior
of buyers or the operations of sellers that cause a shift in the demand curve or the supply curve,
respectively. In the case of the new availability of a close substitute for an existing product, we would
expect the demand curve to shift to the left, indicating that at any market price for the existing good,
demand will be less than it was prior to introduction of the substitute. As another example, consider the

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supply curve for gasoline after an increase in the price of crude oil. Since the cost of producing a gallon
of gasoline will increase, the marginal cost of gasoline will increase at any level of production and the
result will be an upward shift in the supply curve.

It is often of interest to determine the impact of a changing factor on the market equilibrium.
Will the equilibrium quantity increase or decrease? Will the equilibrium price increase or decrease? Will
the shift in the equilibrium point be more of a change in price or a change in quantity? The examination
of the impact of a change on the equilibrium point is known in economics as comparative statics.

In the case of a shifting demand curve, since the supply curve is generally upward sloping, a shift
of the demand curve either upward or to the right will result in both a higher equilibrium price and
equilibrium quantity. Likewise, a shift in the demand curve either downward or to the left will usually
result in a lower equilibrium price and a lower equilibrium quantity. So in response to the introduction
of a new substitute good where we would expect a leftward shift in the demand curve, both the
equilibrium price and quantity for the existing good can be expected to decrease (see Figure 6.5 "Shift of
Market Demand to the Left in Response to a New Substitute and Change in the Market Equilibrium").

Whether a shift in the demand curve results in a greater relative change in the equilibrium price
or the equilibrium quantity depends on the shape of the supply curve. If the supply curve is fairly flat, or
elastic, the change will be primarily in the equilibrium quantity (see Figure 6.6 "Impact of Elasticity of
the Supply Curve on the Impact of a Shift in the Demand Curve"). An elastic supply curve means that a
small change in price typically results in a greater response in the provided quantity. If the supply curve
is fairly vertical, or inelastic, the change in equilibrium will be mostly seen as a price change (see Figure
6.7 "Impact of Elasticity of the Supply Curve on the Impact of a Shift in the Demand Curve").

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A shift in the supply curve has a different effect on the equilibrium. Because the demand curve is
generally downward sloping, a shift in the supply curve either upward or to the left will result in a higher
equilibrium price and a lower equilibrium quantity. However, a shift in the supply either downward or to
the right will result in a lower equilibrium price and a higher equilibrium quantity. So, for the example of
the gasoline market where the supply curve shifts upward, we can expect prices to rise and the quantity
sold to decrease (see Figure 6.8 "Shift of Market Supply Upward in Response to an Increase in the Price
of Crude Oil and Change in the Market Equilibrium").

The shape of the demand curve dictates whether a shift in the supply curve will result in more
change in the equilibrium price or the equilibrium quantity. With a demand curve that is flat, or elastic, a
shift in supply curve will change the equilibrium quantity more than the price (see Figure 6.9 "Impact of
Elasticity of the Demand Curve on the Impact of a Shift in the Supply Curve"). With a demand curve
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that is vertical, or inelastic, a shift in the supply curve will change the equilibrium price more than the
equilibrium quantity (see Figure 6.10 "Impact of Elasticity of the Demand Curve on the Impact of a Shift
in the Supply Curve").

The characterization of a demand curve as being elastic or inelastic corresponds to the measure
of price elasticity that was discussed in Module 3 "Demand and Pricing". Recall from the discussion of
short-run versus long-run demand that in the short run, customers are limited in their options by their
consumption patterns and technologies. This is particularly true in the case of gasoline consumption.
Consequently, short-run demand curves for gasoline tend to be very inelastic. As a result, if changing
crude oil prices results in an upward shift in the supply curve for gasoline, we should expect the result to
be a substantial increase in the price of gasoline and only a fairly modest decrease in the amount of
gasoline consumed.

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G. Why Perfect Competition Is Desirable
In a simple market under perfect competition, equilibrium occurs at a quantity and price where
the marginal cost of attracting one more unit from one supplier is equal to the highest price that will
attract the purchase of one more unit from a buyer. At the price charged at equilibrium, some buyers
are getting a bargain of sorts because they would have been willing to purchase at least some units even
if the price had been somewhat higher. The fact that market demand curves are downward sloping
rather than perfectly flat reflects willingness of customers to make purchases at higher prices.

At least in theory, we could imagine taking all the units that would be purchased at the
equilibrium price and using the location of each unit purchase on the demand curve to determine the
maximum amount that the buyer would have been willing to pay to purchase that unit. The difference
between what the customer would have paid to buy a unit and the lower equilibrium price he actually
paid constitutes a kind of surplus that goes to the buyer. If we determined this surplus for each item
purchased and accumulated the surplus, we would have a quantity called consumer surplus. Using a
graph of a demand curve, we can view consumer surplus as the area under the demand curve down to
the horizontal line corresponding to the price being charged, as shown in Figure 6.11 "Graph of Market
Demand and Market Supply Curves Showing the Consumer Surplus and Producer Surplus When the
Market Is in Perfect Competition Equilibrium".

On the supplier side, there is also a potential for a kind of surplus. Since market supply curves
are usually upward sloping, there are some sellers who would have been willing to sell the product even
if the price had been lower because the marginal cost of the item was below the market price, and in
perfect competition, a producer will always sell another item if the price is at least as high as the
marginal cost. If, as before, we assessed each item sold in terms of its marginal cost, calculated the
difference between the price and the marginal cost, and then accumulated those differences, the sum
would be a quantity called the producer surplus.

2021-2022 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
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 The producer surplus reflects the combined economic profit of all sellers in the short run. For a
graph of the supply curve, the producer surplus corresponds to the area above the supply curve up to
the horizontal line at the market price, again as shown in Figure 6.11 "Graph of Market Demand and
Market Supply Curves Showing the Consumer Surplus and Producer Surplus When the Market Is in
Perfect Competition Equilibrium".

Consumer surplus will increase as the price gets lower (assuming sellers are willing to supply at
the level on the demand curve) and producer surplus will increase as the prices gets higher (assuming
buyers are willing to purchase the added amount as you move up the supply curve). If we asked the
question, at what price would the sum of consumer surplus plus producer surplus would be greatest,
the answer is at the equilibrium price, where the demand curve and supply curve cross.

To support this claim, suppose sellers decided to increase the price above the equilibrium price.
Since consumers would purchase fewer items, the quantity they could sell is dictated by the demand
curve. The new producer surplus, as seen in Figure 6.12 "Change in Consumer Surplus and Producer
Surplus When Sellers Increase Price Above the Equilibrium Price", might be higher than the producer
surplus at the equilibrium price, but the consumer surplus would be decidedly lower. So, any increase in
producer surplus comes from what had been consumer surplus. However, there is a triangular area in
Figure 6.12 "Change in Consumer Surplus and Producer Surplus When Sellers Increase Price Above the
Equilibrium Price", between the supply and demand curve and to the right of the new quantity level,
which represents former surplus that no longer goes to either consumers or producers. Economists call
this lost surplus a deadweight loss.

If the price were lower than the equilibrium price, we encounter a situation where producer
surplus decreases and at best only some of that decrease transfers to consumers. The rest of the lost
producer surplus is again a deadweight loss, as seen in Figure 6.13 "Change in Consumer Surplus and
Producer Surplus When Buyers Force the Price Below the Equilibrium Price".

The important point is that changing the price is worse than just a shift of surplus from
consumers to producers, or vice versa. If the entire sum of consumer surplus and producer surplus could
grow at a different price, it could be argued that the government could use a tax to take some of the
excess received by one group and redistribute it to the other party so everyone was as well off or better

2021-2022 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
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off. Unfortunately, due to the deadweight loss, the gain to one of two parties will not offset the loss to
the other party. So, the equilibrium point is not only a price and quantity where we have agreement
between the demand curve and supply curve, but also the point at which the greatest collective surplus
is realized.

H. Monopolistic Competition
Next, we will consider some slight variations on the perfect competition model. The first is the
oddly named monopolistic competition model. The monopolistic competition model is discussed in
Samuelson and Marks (2010). which uses the same assumptions as the perfect competition model with
one difference: The good sold may be heterogeneous. This means that while all sellers in the market sell
a similar good that serves the same basic need of the consumer, some sellers can make slight variations
in their version of the good sold in the market.

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 As an example, consider midsized passenger automobiles. Some firms may sell cars that are a
different color or different shape, have different configurations of onboard electronics like GPS systems,
and so on. Some firms may make the cars more reliable or built to last longer.

Variation in the product by sellers will only make sense if consumers are responsive to these
differences and are willing to pay a slightly higher price for the variation they prefer. The reason that
slightly higher prices will be necessary is that in order to support variation in product supplied, sellers
may no longer be able to operate at the same minimum efficient scale that was possible when there was
one version of the good that every seller produced in a manner that was indistinguishable from the good
of other sellers.

The fact that firms may be able to charge a higher price may suggest that firms can now have
sustained positive economic profits, particularly if they have a variation of the product that is preferred
by a sizeable group of buyers. Unfortunately, even under monopolistic competition, firms can expect to
do no better than a zero economic profit in the long run. The rationale for this is as follows: Suppose a
firm has discovered a niche variation that is able to sustain a premium price and earn a positive
economic profit. Another firm selling in the market or a new entrant in the market will be attracted to
mimic the successful firm. Due to free entry and perfect information, the successful firm will not be able
to stop the copycats. Once the copycats are selling a copy of this product variation, a process of price
undercutting will commence as was described for perfect information, and prices will continue to drop
until the price equals average cost and firms are earning only a zero economic profit.

I. Contestable Market Model

The contestable market model. The key text on the contestable market model is by Baumol,
Panzar, and Willig (1982). alters a different assumption of the perfect competition model: the existence
of many sellers, each of which is a barely discernable portion of all sales in the market. When we
consider most of the markets that exist in the real world, it is rare that this condition of the perfect
competition model applies. Rather, most markets have sellers that represent a substantial presence and
would noticeably change the market if any one of them would suddenly suspend production and sales.
Also, in many industries, the minimum efficient scale is so large that any firm that manages to increase
to that size will be necessarily contributing a substantial fraction of all market sales.

In the contestable market model, there can be a modest number of sellers, each of which
represents a sizeable portion of overall market sales. However, the assumptions of free entry and exit
and perfect information need to be retained and play a key role in the theory underlying this model. If
buyers in the market know which seller has the lowest price and will promptly transfer their business to
the lowest price seller, once again any firm trying to sell at a higher price will lose all its customers or will
need to match the lowest price.

Of course, it may be argued that the selling firms, by virtue of their size and being of limited
number, could all agree to keep prices above their average cost so they can sustain positive economic
profits. However, here is where the assumption of free entry spoils the party. A new entrant could see
the positive economic profits of the existing sellers, enter the market at a slightly lower price, and still

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earn an economic profit. Once it is clear that firms are unable to sustain a pact to maintain above cost
prices, price competition will drive the price to where firms will get zero economic profits.

In the late 1970s, the U.S. government changed its policy on the passenger airline market from a
tightly regulated market with few approved air carriers to a deregulated market open to new entrants.
The belief that airlines could behave as a contestable market model was the basis for this change.
Previously, the philosophy was that airline operations required too much capital to sustain more than a
small number of companies, so it was better to limit the number of commercial passenger airlines and
regulate them. The change in the 1970s was that consumers would benefit by allowing free entry and
exit in the passenger air travel market. Initially, the change resulted in several new airlines and increases
in the ranges of operations for existing airlines, as well as more flight options and lower airfares for
consumers. After a time, however, some of the larger airlines were able to thwart free entry by
dominating airport gates and controlling proprietary reservation systems, causing a departure from the
contestable market model. A good account of airline industry deregulation is in chapter 9 of Brock
(2009).

J. Firm Strategies in Highly Competitive Markets

Markets that closely resemble the perfect competition model or its variants might be ideal from
the standpoint of market customers and as a means of increasing social surplus. From the perspective of
individual selling firms, highly competitive markets require that sellers carefully attend to cost and
market conditions, while promising only modest returns on assets and invested capital for those firms
that manage to survive. Despite the limited opportunity for profit in these markets over the long run,
good and well-executed strategies can help firms in these markets be among the survivors and perhaps
extend the period in which they can do better than sell products at average cost.

Michael Porter of Harvard University prepared a guidebook for firms to prevail in these
competitive markets in his text Competitive Strategy. See Porter (1980). Basically, he advises that firms
adopt an aggressive program to either keep their costs below the costs of other sellers (called a cost
leadership strategy) or keep their products distinguishable from the competition (called a product
differentiation strategy). The logic of either of these strategies can be viewed as trying to delay the
development of the assumed conditions of perfect competition, so as to delay its long-run conclusions
of zero economic profit.

The perfect competition model allows that some firms will do better than others in the short run
by being able to produce a good or service at lower cost, due to having better cost management,
production technologies, or economies of scale or scope. However, the model assumption of perfect
information means that any firms with cost advantages will soon be discovered and mimicked. The cost
leadership strategy prescribes that firms need to continually look for ways to continue to drive costs
down, so that by the time the competition copies their technology and practices, they have already
progressed to an even lower average cost. To succeed, these programs need to be ongoing, not just
done once.

The monopolistic competition model allows for some differentiation in a product and the
opportunity to charge a higher price because buyers are willing to pay a premium for this. However, any
2021-2022 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines
short-run opportunity for increased economic profit from selling a unique version of the product will
dissipate as the competition takes notice and copies the successful variant. Porter’s product
differentiation strategy is basically a steady pursuit of new product variants that will be prized by the
consumer, with the intent of extending the opportunity for above-normal profits. However, as with the
cost leadership strategy, to be successful, a firm must commit itself to continued product differentiation
with up-front investment in development and market research.

Porter suggests that each of his two strategies may be geared toward participation in a broader
market or limited to a particular segment of the market, which he calls a focus strategy. A focus strategy
endeavors to take advantage of market segmentation. As we discussed in Module 3 "Demand and
Pricing", the population of buyers is not usually homogeneous; some are willing to pay a higher price
(less price elastic) and some are willing to purchase in greater volume. By focusing on a particular
segment, a firm may be able to maintain an advantage over other sellers and again forestall the onset of
the long-run limitations on seller profits. The goal of the focus strategy is to be able to serve this
segment either at lower cost or with product variations that are valued by the customer segment. Of
course, by focusing on just one or a subset of buyer segments, a firm loses the opportunity for profits in
other segments, so depending on the product, the circumstances of the market, and the assets of the
firm, a broader application of cost leadership or product differentiation may be better.

The potential for success using a cost leadership strategy or a product differentiation strategy
might suggest that a firm can do even better by practicing both cost leadership and product
differentiation. Porter advises against this, saying that firms that try to use both strategies risk being
“stuck in the middle.” A firm that tries to be a cost leader will typically try to take advantage of scale
economies that favor volume over product features and attract customers who are sensitive to price.
Product differentiation seeks to attract the less price sensitive customer who is willing to pay more, but
the firm may need to spend more to create a product that does this. Firms that try to provide a good or
service that costs less than the competition and yet is seen as better than the competition are
endeavoring to achieve two somewhat opposing objectives at the same time.

References

2021-2022 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines
 Brickley, J. A., Smith, C. W., Jr., & Zimmerman, J. L. (2001). Managerial economics and organizational
architecture. New York, NY: McGraw-Hill Irwin.

Hirschey, M., Managerial Economics 12th ed. Pasig City: Cengage Learning Asia Pte Ltd. 2012.

Milgrom, P. R., & Roberts, J. (1992). Economics, organization & management. Englewood Cliffs, NJ:
Prentice Hall. Mishan, E. J. (1976). Cost-benefit analysis. New York, NY: Praeger.

Samuelson, W., Marks, S. Managerial Economics. John Wiley and Sons Inc. 2016

Thomas, C, Maurice, C., Manager Economics, Foundations of Business Analysis and Strategy 12th ed
International Edition. Mc Graw Hill 2016

Varian, H. A. (1993). Intermediate microeconomics (3rd ed.). New York, NY: W. W. Norton & Company.
Wernerfelt, B. (1984). A resource-based view of the firm.

Wikenson, N. Managerial Economics: A Problem Solving Approach. Harvard, Cambridge University

Press 2015

2021-2022 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines