Hill – Mankiw 9th Edn Chapter 14 – Firms in Competitive Markets
Mankiw, N. G. (2021) Principles of microeconomics (9th ed.)
Principles of economics (9th ed.)
Mason, OH: South-Western Cengage Learning.
University of New Brunswick, Saint John campus
Saint John, New Brunswick, Canada
Chapter 14 – Firms in Competitive Markets
Here are some things to consider when reading this chapter.
- Why begin the study of market structures with perfectly competitive firms and markets?
Mankiw poses this question and offers two reasons (p. 264). Before considering those, let’s note that from Chapter 4 onwards the book has carried out analysis exclusively using perfectly competitive markets in the form of the supply and demand model. Even Chapter 13 on costs of production, with its insistence on increasing marginal costs in the short run and diminishing returns to scale in the long run, ignored the empirical evidence in order to provide an underpinning for firms in perfectly competitive markets.
(i) Is the perfectly competitive firm/market simpler to understand than firms in other market structures?
Mankiw writes: “because competitive firms have negligible influence on market prices, they are simpler to understand than firms with market power.” One could agree with this statement about the individual firm, yet be unconvinced that the perfectly competitive market is simpler than, for example, a market that consists of a single monopolistic firm. Firms in both types of markets adjust production to maximize profits in both the short and the long run as demand changes, and the monopoly has the additional task of choosing its price. But the analysis of perfect competition involves distinguishing between the supply and demand curves of individual firms and the supply and demand in the market as a whole; it also involves the complications of entry/exit of firms, as illustrated in Figure 8 (p. 280), with feedback effects on the market price and the profits of individual firms. With monopoly, these complications do not arise.
(ii) Is the perfectly competitive market a useful benchmark for comparison with other market structures?
Mankiw writes that “because competitive markets allocate resources efficiently (as we saw in Chapter 7) they provide a benchmark against which we can compare other market structures” (p. 264). The introductory textbooks focus on partial equilibrium models, i.e. models of a single market. This contrasts with general equilibrium which deals with the simultaneous equilibrium of all markets in the economy. (Mankiw uses the phrase ‘general equilibrium’ only twice [p. 368].)
As a result, the details of the requirements for the efficient allocation of resources in the economy as a whole are glossed over. For competitive markets to allocate resources efficiently, all markets must be perfectly competitive and there can be no sources of market failures of any kind – such as externalities, imperfect information, transactions costs, among other things. Clearly, this is an imaginary economy that could never exist.
In light of this, Mark Blaug wrote
All the current textbooks… say that the cloud-cuckoo-land of perfect competition is the benchmark against which economists may say something significant about real-world competition… But how can an idealized state of perfection be a benchmark when we are never told how to measure the gap between it and real-world competition? It is implied that all real-world competition is ‘approximately’ like perfect competition but the degree of the approximation is never specified, even vaguely.” (2002, p. 38)
Indeed, Mankiw makes this claim explicitly at the end of the next chapter: “It is true that many firms have some monopoly power [i.e. ability to choose the price of their product]. It is also true that their monopoly power is usually limited. In such situations we will not go far wrong assuming that firms operate in competitive markets, even if that is not precisely the case.” (p. 312, my emphasis)
- The characteristics of perfectly competitive markets
According to Mankiw, there are two essential characteristics: there are many buyers and sellers in the market and “the goods offered by the various sellers are largely the same” (p. 264, my emphasis). The definition of a competitive market, found in the margin, contradicts this by correctly saying that the products offered by sellers are identical to each other. Only identical products offered by sellers can be added together to determine market supply. The rhetorical choice of the phrase “largely the same” leaves room for some differences in characteristics of producers’ outputs, thus making this market structure resemble more actual markets than it really does.
To be truly identical, the products must also be available at essentially the same time and in the same location, because otherwise they would not be perfect substitutes. After all, a potential buyer could well consider a chocolate ice cream cone being sold 100 metres away from her location as a different product than a chocolate ice cream cone being sold 1000 metres away (and therefore also available at a later time), even if the price and the brand of the ice cream were exactly the same. How far apart the sellers would have to be from each other to give them enough power to charge different prices depends on the price sensitivity of buyers and how informed they are about prices. Ice cream is also differentiated by the use of brand names created by advertising, which may sway buyers’ judgements even if a blind taste test could not distinguish between them.
Mankiw explains that together large numbers on both sides of the market and identical or ‘homogeneous’ products imply that “each buyer and seller takes the market price as given” (p. 264). This contradicts the statement on the previous page: “a market is competitive if each buyer and seller… has little ability to influence market prices” (p. 263, my emphasis). Again, is this phrase there to make the perfectly competitive model seem less restrictive and more applicable to real-world markets?
Mankiw adds a third characteristic that is “sometimes thought” to characterize perfectly competitive markets: “firms can freely enter or exit the market”. It’s correct that, as he writes, “this condition is not necessary for firms to be price takers”, but virtually every other text mentions free entry/exit, without qualification, as a fundamental feature of this market structure. Nevertheless, Mankiw uses the assumption to show that in the long run, once entry/exit is complete, competitive firms produce products at the minimum average total cost (as illustrated in Figure 8). By downplaying the assumption of costless entry and exit, Mankiw’s description again broadens the apparent applicability of perfect competition to real-world markets.
Finally, as he did in Chapter 4, Mankiw omits mention of a fourth characteristic that is of crucial importance: “Perfect information. Each firm and each customer is well informed about available products and prices. They know whether one supplier is selling at a lower price than another” (Baumol et al., 2020, p. 196). This feature of the market is necessary for there to be a single market price, as noted earlier in the Commentary to Chapter 4. However, even that is not sufficient to guarantee a single market price unless it costs buyers a negligible amount (from the buyer’s point of view) to switch from one supplier to another. The gasoline example earlier in this section is relevant here; the distance between gasoline stations and the imperfect information that customers are likely to have allows prices to be different. (The gasoline market is described in more detail in the next section.)
Texts, like William Baumol’s, that mention perfect information also note that “these exacting requirements [for perfect competition] are rarely, if ever, found in practice” (Baumol et al. 2020, p. 196). On the other hand, those texts that leave this assumption implicit, make broader claims for the applicability of the perfectly competitive model to real world markets. Mankiw’s text falls squarely into this latter camp.
‘Perfect information’ just means that acquiring information is costless. The Commentary for Chapter 4 summarized Joseph Stiglitz’s argument that if there is just a very small cost to acquiring information, such as about the price another seller is asking for its product, firms would have the ability to charge the monopoly price (Stiglitz 2002, p. 477).
In Stiglitz’s view, “a central consequence of imperfect information is that … product markets are more aptly described by models of imperfect competition, where … [firms] perceive themselves facing downward sloping demand schedules” (Stiglitz 1985, p. 34). Such models are described in the next three chapters.
- The markets given as examples of perfect competition are better described by other market models
Although no actual markets satisfy the requirements of perfect competition, textbook authors nevertheless need to come up with superficially plausible examples to convince students of the applicability of the model to some real markets. Like Mankiw, they fail to cite any actual studies of these markets. In the case of the two markets used by Mankiw in this chapter, such studies exist and find no use for the perfectly competitive model.
(i) The retail gasoline market
The chapter begins with an example of gasoline stations as firms in a competitive industry (p. 263). If the perfectly competitive model accurately predicted behaviour in this market, all sellers would charge the same price.
A study by Canadian economists Andrew Eckert and Douglas West directly examined this prediction using data on gasoline prices from Vancouver, British Columbia. They wrote “contrary to the competitive model, variables measuring brand effects, spatial and product characteristics, local market structure” are among the things that “affect the probability that a station matches the market mode price” (2005, p. 219). (The mode price is the price that appears most frequently at any point in time in the data. It would be the price charged by all stations in a perfectly competitive market.)
They write: “If the competitive market model can be rejected, one can then determine whether the pricing pattern is more consistent with the type of pattern that could result from alternative types of pricing behavior. Two alternative types of pricing in the retail gasoline market are considered: tacitly collusive pricing at the brand level and imperfectly competitive, non-collusive pricing in a spatial market [i.e. a market in which the distance between sellers is explicitly considered]” (2005, p. 220). Of the two alternative models to perfect competition, they conclude that the data are most supportive of a model of tacit collusion. (The Commentary for Chapter 17 discusses this concept further.)
There are other studies of actual retail gasoline markets and the complex pattern of prices that they exhibit. A variety of models have been proposed and tested, including oligopoly models of competition and price wars, collusion, and price discrimination, concepts explained in the next two chapters of Mankiw’s text. The competitive model, however, is of no use in explaining the diverse prices charged by sellers at any particular time, nor movements in prices over time.
(ii) The market for milk
In a perfectly competitive market, buyers and sellers take the market price as given. Mankiw offers this example (p. 264):
consider the market for milk. No single consumer of milk can influence the price of milk because each buys a small amount relative to the size of the market. Similarly, each dairy farmer has limited control over the price because many other sellers are offering milk that is essentially identical. Because each seller can sell all he wants at the going price, he has little reason to charge less, and if he charges more, buyers will go elsewhere. Buyers and sellers in competitive markets must accept the price the market determines and, therefore, are said to be price takers.
The chapter’s central example of a perfectly competitive firm is a dairy farm. This choice is further justified by the observation that this farm “is small compared with the world market for milk, [so] it takes the price as given by market conditions” (p. 265, my emphasis). In this imaginary world market, all the milk consumers in the world buy milk directly from all the dairy farmers in the world at the world price of milk.
This is a classic example of the simple textbook assumption of a market consisting of just two groups: consumers and producers trading directly with each other. As we saw in the example in Chapter 4 of wheat farmers selling wheat directly to final consumers of wheat products, this ignores the complex production and distribution chains that are involved in bringing goods and services to places where consumers may buy them.
In reality, dairy farmers sell their milk to processors, who may sell it to wholesalers who sell to retailers like supermarkets, who then sell it to the final buyer. None of the markets in which this series of transactions take place are likely to resemble perfect competition.
Consider the first market, where milk producers sell to processors. In the United States, the federal government’s Department of Agriculture (USDA) oversees the Federal Milk Marketing Order program that establishes the minimum prices dairy farmers receive for their milk. According to the International Dairy Foods Association, the program, introduced during the 1930s, covers 11 areas of the country and applies to about 75% of total U.S. milk production. These minimum regulated prices for milk are based on the wholesale prices of milk products (fluid milk; soft products such as ice cream and yogurt; cheese, and butter and milk powder).
The objective of these Milk Marketing Orders is “to improve terms of trade and the bargaining process between milk producers and milk processors and to increase returns to dairy farmers” (Bolotova 2021, p. 41). Clearly these would be unnecessary in a perfectly competitive market where milk processors would have no market power. That market power has also been an impetus to the formation of farmer-owned dairy cooperatives, who both bargain with milk processors and act as their own processors and marketers of their products. Even so, dairy farmers can still face anticompetitive practices by producers. (See Bolotova 2021, pp. 39-41 for an example.)
At the other end of the chain of distribution, where retailers sell to final consumers, there is evidence of noncompetitive pricing. For example, a study of supermarkets in the western United States found that “retail price responses to farm price changes are consistent with monopoly pricing behavior for several of the milk products in several of the markets” (Carman and Sexton 2005, p. 509).
(iii) Coase on Blackboard Economics
Mankiw’s markets for milk and gasoline are examples of what Ronald Coase called ‘blackboard economics’. As he put it: “What is studied is a system which lives in the minds of economists but not on earth. … The firm and the market appear by name but they lack any substance” (1994, p. 5). In the case of “the market for milk”, supply and demand curves are drawn and the curves are shifted as stories are told, but no attention is paid to the relationship between the theory and actual market institutions.
Institutional detail is also ignored in the story of how the competitive firm maximizes profits and, in the long run, produces goods at the lowest possible average cost. But what goes on within the firm (both here and at other market structures) is not specified. As Coase remarked:
The firm in mainstream economic theory has often been described as a ‘black box.’ And so it is. This is very extraordinary given that most resources in a modern economic system are employed within firms, with how these resources are used dependent on administrative decisions and not directly on the operation of a market. Consequently the efficiency of the economic system depends to a very considerable extent on how these organisations conduct their affairs, particularly, of course, the modern corporation. (1994, pp. 5-6)
- What model of a market is most appropriate in a particular situation?
In Mankiw’s text this question has not yet arisen because only one model – that of the perfectly competitive market – has been employed. As the examples in the previous section showed, this model has been used regardless of the characteristics of the actual markets.
As noted in the Commentary to Chapter 2, a model in economics has a particular domain within which it can be usefully applied. Like all economic models, the perfectly competitive model makes simplifying assumptions that are not true in reality. This wouldn’t matter if the violation of any of the false assumptions had a negligible effect on the conclusions or predictions of the model. As described in the Commentary to Chapter 4, moving from the assumption of perfect/costless information to even a small cost of acquiring information in a market led to a very different prediction about market prices (which would change from the perfectly competitive price to the monopoly price). The fragility of the perfectly competitive model suggests that its domain of applicability is extremely limited.
However, as quoted earlier, Mankiw claims broad applicability for the perfectly competitive model when he writes that “we will not go far wrong assuming that firms [with some power to set prices] operate in competitive markets, even if that is not precisely the case” (p. 312). It may be the case that the perfectly competitive model makes the same predictions for some questions as do competing models of markets. For example, if firms’ costs increase, all the market models in the text would suggest that firms’ prices will increase. So, using the perfectly competitive model would give an acceptable prediction about the direction of price change.
But as seen in the previous section, the perfectly competitive model is of no use in explaining the strategies that firms adopt in setting prices in gasoline markets. Because it overlooks the market power of milk processors, it can’t explain price formation in American milk markets, even in the absence of government mandated minimum prices. It would also be unable to explain why producer cooperatives exist because it ignores the market power of milk processors.
Up to this point in the text, the perfectly competitive model has been presented as if it is true and can be applied directly to real-world situations without discussion. The critical question of which model is most suitable in a particular set of circumstances has not arisen, but it can be asked once other models of markets are introduced in the next three chapters.
Bolotova, Yuliya V. (2021) “Market Power in the Fluid Milk Industry in the Eastern United States”, Applied Economics Teaching Resources, 3(2): 39-67.
Baumol, William., Allan Blinder and J. Solow (2020) Microeconomics: Principles and Policy, 14th ed., Cengage.
Blaug, Mark (2002) “Ugly currents in modern economics”, in Uskali Mäki (ed.), Fact and Fiction in Economics: Models, Realism and Social Construction, Cambridge University Press, pp. 35–56.
Carman, Hoy F. and Richard J. Sexton (2005) “Supermarket Fluid Milk Pricing Practices in the Western United States”, Agribusiness, 21(4): 509–30.
Coase, Ronald H. (1994) Essays on Economics and Economists, University of Chicago Press.
Eckert, Andrew and Douglas West (2005) “Price uniformity and competition in a retail gasoline market”, Journal of Economic Behavior & Organization, 56: 219-37.
Stiglitz, Joseph (1985) “Information and economic analysis: a perspective”, Economic Journal, 95, Supplement: Conference Papers, pp. 21–41.
Stiglitz, Joseph (2002) “Information and the change in the paradigm in economics”, American Economic Review, 92(3): 460–501.