PRIVATE AND PUBLIC CHOICE

16TH EDITION

GWARTNEY – STROUP – SOBEL – MACPHERSON

Price-Searcher Markets
with Low Entry Barriers
Full Length Text — Part: 5 Chapter: 23
Micro Only Text — Part: 3 Chapter: 10

To Accompany: “Economics: Private and Public Choice, 16th ed.”

James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides prepared by Joseph Connors with the assistance of Charles Skipton & James Gwartney
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 Competitive
Price-Searcher Markets

16 th
edition
Gwartney-Stroup
Sobel-Macpherson

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 16 th
edition

Competitive Price-Searcher Markets Gwartney-Stroup

Sobel-Macpherson

• Firms in competitive price-searcher markets with low

entry barriers face a downward sloping demand curve.
• Firms are free to set price, but face strong competitive
pressure.
• Competition exists from existing firms and potential
rivals.
• An alternative term for such markets is monopolistic
competition.

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 16 th
edition

Product Differentiation Gwartney-Stroup

Sobel-Macpherson

• Price searchers produce differentiated products

– products that differ in design, dependability, location,
ease of purchase, etc.
• Rival firms produce similar products (good substitutes)
and therefore each firm confronts a highly elastic
demand curve.

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 16 th
edition

Price and Output Gwartney-Stroup

Sobel-Macpherson

• A profit-maximizing price searcher will expand output

as long as marginal revenue exceeds marginal cost.
• Price will be lowered and output expanded until
MR = MC.
• The price charged by a price searcher will be greater than
its marginal cost.

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 16 th
edition
Marginal Revenue of a Price Searcher Gwartney-Stroup
Sobel-Macpherson

• Consider the market for a product with Price

Reduction in
initial price P1 & output q1. Total revenue Total Revenue
(TR) = P1 x q1.
• With a downward sloping demand curve,
price reductions that increase sales will Increase in
exert two conflicting influences on TR. P1 Total Revenue
• As the price falls from P1 to P2, output P2
increases from q1 to q2. What effect does
this have on TR?
• First, TR will rise because of an increase in d
the number of units sold (q2 – q1) x p2.
• But, TR will decline by [(P1 – P2) x q1] as
q1 units once sold at the higher price (P1)
MR
are now sold at the lower price (P2). Quantity
/time
• Because of these two conflicting effects, q1 q2
marginal revenue (MR) will be less than P.
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 16 th
edition
Price and Output: Short-Run Profit Gwartney-Stroup
Sobel-Macpherson

Price
MC
Economic
• A price searcher maximizes profits by Profits
producing where MR = MC, at output
level q … charging price P along the ATC
demand curve for that output level. P
• At q the average total cost is C.
• Because the price is greater than the C
average total cost per unit (P > C) the
firm is making economic profits equal d
to the area ( [ P - C ] x q ).
• What impact will economic profits
have if this is a typical firm? MR

Quantity/time
q

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 16 th
edition

Profits and Losses in the Long Run Gwartney-Stroup

Sobel-Macpherson

• If firms are making economic profits, then rival firms will be

attracted to the market.
• The entry of new firms will expand supply and lower price.
• The demand curve of each will shift inward until the
economic profits are eliminated.
• Economic losses will cause price searchers to exit from the
market.
• Demand for the remaining firms’ output will rise until the
losses have been eliminated, removing the incentive to exit.
• Competitive price searchers can make either profits or losses
in the short run, but only zero economic profit in the long run.

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 16 th
Long Run in a edition
Gwartney-Stroup

Competitive Price-Searcher Market Sobel-Macpherson

Price MC
• Because entry and exit are free,
competition will eventually drive
prices down to the level of ATC.
• When profits (losses) are present, ATC
the demand curve will shift inward
(outward) until the zero profit
equilibrium is restored. C = PP
• The price searcher establishes its
output level where MC = MR.
• At q the average total cost is equal
to the firm’s price P. As a result,
zero economic profit is present.
d
No incentive for firms to either enter
or exit the market is present. MR
Quantity/time
q

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 Contestable Markets and
the Competitive Process

16 th
edition
Gwartney-Stroup
Sobel-Macpherson

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 16 th
edition

Contestable Markets
Gwartney-Stroup
Sobel-Macpherson

• A contestable market is one in which entry and exit costs

are low and there are no legal barriers to entry.
• Example: Airline industry
• Actual and potential competition leads to:
• Zero economic profits
• Efficient production

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 Evaluating Competitive
Price-Searcher Markets

16 th
edition
Gwartney-Stroup
Sobel-Macpherson

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 16 th
edition

Comparing Price Searchers and Takers Gwartney-Stroup

Sobel-Macpherson

• Here, we illustrate the

long-run equilibrium for
both price-taker and
price-searcher markets Price MC Price MC
with low entry barriers.
• With each, P = ATC ATC ATC
and so there are no
economic profits. P2
• As the price searcher P1 d
faces a downward-
sloping demand curve,
its profit-maximizing d
price exceeds MC. Quantity MR Quantity
In contrast with the /Time /Time
q1 q2
price-taker market, the
Price-taker Firm Price-searcher Firm
price-searcher’s q is too
small to minimize ATC
in long-run equilibrium.

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 16 th
edition

Comparing Price Searchers and Takers Gwartney-Stroup

Sobel-Macpherson

• Even though the two

markets have the Price MC Price MC
same cost structure,
the price
in the price-searcher ATC ATC
market is higher than
that in the price-taker P2
market ( P2 > P1 ). P1 d
• Some consider this
price discrepancy a
sign of inefficiency; d
Quantity MR Quantity
others perceive it as /Time /Time
the price paid for q1 q2
product variety & Price-taker Firm Price-searcher Firm
dynamic improvement
in products over time.

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Questions for Thought: 16 th
edition
Gwartney-Stroup
Sobel-Macpherson

1. What are the distinguishing characteristics of competitive

price-searcher markets? Indicate a market that
approximates these conditions.
2. Price searchers can set the price of their product. Does
this mean price searchers will charge the highest possible
price? What price will maximize the profits of a price
searcher?
3. In price‑searcher markets with low barriers to entry, will
the firms be able to make economic profit in the long
run? Why or why not? What do competitive price
searchers have to do in order to make economic profit?

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Questions for Thought: 16 th
edition
Gwartney-Stroup
Sobel-Macpherson

4. Which of the following is a necessary condition for

long-run equilibrium in both competitive price-searcher
and competitive price-taker markets?
(a) Price must equal marginal cost (MC).
(b) The typical firm in the market must be earning
zero-economic profit.
(c) All of the firms in the market must be charging
the same price.

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 A Special Case:
Price Discrimination

16 th
edition
Gwartney-Stroup
Sobel-Macpherson

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 16 th
edition

Price Discrimination
Gwartney-Stroup
Sobel-Macpherson

• Price discrimination:
When a seller charges different consumers different
prices for the same good or service.
• Price discrimination can only occur when a price searcher
is able to:
• identify groups of customers with different price
elasticities of demand, and,
• prevent customers from re-trading the product.

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 16 th
edition

Price Discrimination
Gwartney-Stroup
Sobel-Macpherson

• Sellers may gain from price discrimination by charging

• higher prices to groups of customers with more
inelastic demand, and,
• lower prices to groups of customers with more
elastic demand.
• Price discrimination generally leads to more output and
additional gains from trade.

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The Economics of Price edition
16price
Single th

Net operating revenue

Price Discrimination $600
Gwartney-Stroup
($300x 100) = $30,000
Sobel-Macpherson

$500
$400
• Consider a hypothetical market for $300
airline travel where the Marginal Cost
$200
per traveler is $100.
$100 MC
• If airlines charges all customers the MR D
same price, profits will be maximized Quantity
100 /time
where MC = MR .
• Here the airline charges everyone $400
and sells 100 seats
• This generates Net Operating Revenue
of $30,000 or (total revenues) $40,000
minus (operating costs) $10,000.

15 th
edition
Gwartney-Stroup
Sobel-Macpherson

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The Economics of Price edition
16price
Single th

Net operating revenue

Price Discrimination $600
Gwartney-Stroup
($300x 100) = $30,000
Sobel-Macpherson

$500
$400

• By charging higher prices to consumers $300

with less elastic demand and lower $200
prices to those with more elastic $100 MC
demand it will increase net operating MR D
Quantity
revenue. 100 /time

• If the airline charges $600 to business Price Price Discr.

travelers (who have a highly inelastic $600
Net operating revenue
from business travelers
demand) and $300 to other travelers ($500x 60) = $30,000
$500
(who have a more elastic demand), Net operating revenue
from all others
it can sell more seats (120 versus 100) $400
($200x 60) = $12,000
and increase its Net Operating Revenue $300
to $42,000. $200
$100 MC
D
Quantity
60 120 /time
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 Entrepreneurship
and Economic Progress

16 th
edition
Gwartney-Stroup
Sobel-Macpherson

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 16 th
edition

Keys to Prosperity: Entrepreneurship Gwartney-Stroup

Sobel-Macpherson

• Entrepreneurship: Entrepreneurial
judgment and the development of
improved products and production
processes are a central element of
economic progress.
• Entrepreneurial judgment is necessary when there is no
decision rule that can be applied using only information that
is freely available.
• For this reason, we are unable to incorporate fully the
function of the entrepreneur into economic models.
• There simply is no way to model these complex decisions
that involve uncertainty, discovery, and business judgment.
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 16 th
edition

Entrepreneurs and Economic Progress Gwartney-Stroup

Sobel-Macpherson

• An entrepreneur is someone who finds new combinations

of resources and creates new products and production
methods that did not previously exist.
• Entrepreneurs who discover and introduce lower-cost
production methods and new products that are highly
valued relative to cost promote economic progress.
• Entrepreneurs also have a strong incentive to discover the
type of business structure, size of firm, and scope of
operation that can best keep the per-unit cost of products
or services low.

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 16 th
edition

Entrepreneurs and Economic Progress Gwartney-Stroup

Sobel-Macpherson

• A growing, vibrant economy will be characterized by the

constant introduction of new products and services.
• Nobody knows what the next innovative breakthrough will
be or who will discover and develop it.
• The only real test of a new product or service is to try it out
within the framework of the competitive market process.
• The rate of discovery will depend on the structure of
rewards. In economies where it is attractive to discover new
ways of doing things, the discovery rate of wealth creating
opportunities will be higher and human progress more
rapid.

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Dynamic Competition, Innovation, 16 th
edition

and Business Failures Gwartney-Stroup

Sobel-Macpherson

• Business failures are usually reported as bad news about

the economy.
• Though business failures are painful for those directly
involved, they release resources so they can be employed
more productively elsewhere.
• The assets and workers of failed firms become available
for use by others supplying goods that consumers value
more relative to costs.
• Without this release of resources, economic expansion
would be slowed.

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Dynamic Competition, Innovation, 16 th
edition

and Business Failures Gwartney-Stroup

Sobel-Macpherson

• The introduction of new and improved products often

lead to obsolescence of others. Joseph Schumpeter
referred to this process as ‘creative destruction.’
• In a competitive economy numerous businesses regularly
come and go. Each year newly created businesses account
for about 10% of the total but 60% of them will fail within
six years.

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Questions for Thought: 16 th
edition
Gwartney-Stroup
Sobel-Macpherson

1. Is price discrimination harmful to the economy? How

does price discrimination affect the total amount of gains
from exchange? Explain. Why do colleges often charge
students different prices, based on their family income?
2. What is the primary requirement for a market to be
competitive? How does competition influence (a) the
cost efficiency of producers and (b) the quality of
products. What determines whether a good will continue
to be produced in a competitive market?

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Questions for Thought: 16 th
edition
Gwartney-Stroup
Sobel-Macpherson

3. When competitive forces are present, sometimes firms

will make losses and be driven out of business. Would
our standard of living be higher if the government
provided subsidies to troubled firms so that they would
not have to go out of business?
Why or why not?
4. What is the role of the entrepreneur? Why is
entrepreneurial discovery and development of improved
products and production processes a central element of
economic progress?

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Questions for Thought: 16 th
edition
Gwartney-Stroup
Sobel-Macpherson

5. Which of the following indicates that a firm operating

in the highly competitive retail sector is providing goods
and services that consumers value highly relative to their
cost?
(a) The firm is making losses and its sales are declining.
(b) The wages earned by the employees of the firm are
low.
(c) The firm is highly profitable and its sales have grown
rapidly.

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 End of
Chapter 23

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