Firms’ in Competitive Markets

Your local gas station raised its price for gasoline by 20 percent, it would see a ‘large drop in the amount of gasoline it sold. Its customers would quickly switch to buying their gasoline at other gas stations. By contrast, if your local water company raised the price of water by 20 percent, it would ‘see only a small decrease in the amount of water it sold. People might water their lawns less often and buy more water efficient shower heads, but they would be hard pressed to reduce water consumption greatly and would be unlikely to find another supplier. The difference between the gasoline market and the water market is obvious: There are many firms pumping gasoline, but there is only one firm pumping water. As you might expect, this difference in market structure shapes the pricing and production decisions of the firms that operate in these markets.

In this chapter, we examine the behavior of competitive firms, such as your local gas station. You may recall that a market is competitive if each buyer and seller is small compared to the size of the market and, therefore, has little ability to influence market prices. By contrast, if a firm can influence the market price of the good It sells, it is said to have market power. Later in the book, we examine the behavior of firms with market power, such as your local water company.


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