Econ Lab · Markets
Competition and market structure
A new cafe opens on a busy street and the queue is out the door. Within a year three more have opened beside it, and the profit has quietly vanished. No one planned that. It is just what happens when anyone is free to enter and chase a price that sits above cost.
Slide the market price and watch where the entry pressure pushes it back to.
Every cafe faces the same costs. Marginal cost is what one more cup adds. Average total cost spreads the fixed costs over all the cups, so it falls then rises, bottoming out where marginal cost crosses it.
At dollars a cup the price clears the bottom of the average-cost curve by dollars. Price beats average cost, so every cup sold leaves something over and each cafe earns a profit. Profit is a signal anyone can see, so outsiders open cafes too. More cafes means more cups for sale, and the only way to shift them all is a lower price. The price slides down toward dollars a cup, and it keeps sliding until the profit that drew newcomers in is gone.
Move the price slider. The dashed line is the going market price, the triangle is the only point free entry can rest at.
Two cost curves
Marginal cost is what one more cup adds. Average total cost spreads every cost, the rent and the beans, over all the cups sold. At low volume the rent is split too few ways, so the average is high. As cups grow it falls, then the rising cost of each extra cup pulls it back up. That is the U.
Where they cross
Marginal cost cuts average cost at the very bottom of the U. That is not a coincidence. While each new cup costs less than the running average, it drags the average down. Once it costs more, it pulls the average up. So they meet exactly where the average stops falling and starts rising.
What free entry does
Set the price above two dollars and every cafe is making a profit. That profit is a signal, and it is not a secret. New cafes open, supply rises, and the price is competed down. Set the price below two dollars and cafes are losing money, so some close and leave, supply shrinks, and the price drifts back up.
The only resting point
The price can only settle at the bottom of the average-cost curve. There price equals marginal cost equals the minimum average cost, and economic profit is exactly zero. Cafes still cover their rent and their owners' time, but nothing extra is left to lure the next entrant. That zero-profit floor is what competition means.