Ch09 pure competition[1]

Chapter Objectives

• The four basic market models • Characteristics of pure competition • Profit maximization for competitive

firms in the short • The competitive firm supply curve • Profit Maximization in the long-run • Pure competition and Efficiency

Four Market Models • Pure competition

• Pure monopoly

• Monopolistic competition

• Oligopoly

Market Structure Continuum

Pure Competition

Monopolistic Competition Oligopoly

Pure Monopoly

Imperfect Competition

• Imperfect competition refers to those market structures

that fall between pure competition and pure monopoly.

The Four Types of Market Structure

Copyright © 2004 South-Western

• Local electric

utility

Pure

Monopoly

• Clothing

• Furniture

Monopolistic

Competition

• Tennis balls

• Crude oil

Oligopoly

Number of Firms?

Pure

• Wheat

• Milk

Competition

Type of Products?

Identical

products

Differentiated

products

One

firm

Few

firms

Many

firms

Characteristics of pure competition

• A perfectly competitive market has the following

characteristics:

– Very large numbers : There are many buyers

and sellers in the market (examples: markets

for farm commodities, the stock market, the

foreign exchange market).

– Standardized product: The goods offered by

the various sellers are largely the same.

Characteristics of pure competition • “Price takers”:

– Each buyer and seller takes the market price as given.

– Buyers and sellers must accept the price determined by the market.

• Free entry and exit: Firms can freely enter or exit the market. There are no obstacles prohibit new firms from selling their output in any competitive market.

Demand of Pure Competition • Perfectly elastic demand

– We need to analyze the demand of a pure competition firm to see how it affects revenue.

– The demand faced by the individual firm in a pure competition market is perfectly elastic at the market price.

– We are not saying that market demand is perfectly elastic.

– All firms acting independently can increase price by reducing output. But individual competitive firm cannot do that.

Demand of Pure Competition

• no individual firm can affect the market price

• demand curve facing each firm is perfectly elastic

The Revenue of a Competitive Firm

• Average revenue (AR) tells us how much revenue a

firm receives for the typical unit sold.

• Average revenue is total revenue divided by the

quantity sold.

Average Revenue =Total revenue

Quantity

Price Quantity

Quantity

Price


• Total revenue (TR) for a firm is the selling price

times the quantity sold.

TR = (P Q)

• Marginal revenue (MR) is the change in total

revenue (or the extra revenue) from selling one

more unit of output.

MR = TR/ Q


• In pure competition, marginal revenue and price

are equal (MR = P).

Firm’s Demand Schedule (Average Revenue)

Firm’s Revenue

Data

Demand, Total Revenue, Average Revenue, and

Marginal Revenue for a Competitive Firm

Pri

ce

an

d R

eve

nu

e

2 4 6 8 10 12

131

262

393

524

655

786

917

1048

$1179

Quantity Demanded (Sold)

D = MR = AR

TR

P QD TR MR

$131

131

131

131

131

131

131

131

131

131

131

0

1

2

3

4

5

6

7

8

9

10

$0

131

262

393

524

655

786

917

1048

1179

1310

$131

131

131

131

131

131

131

131

131

131

] ] ] ] ] ] ] ] ] ]

Demand, Total Revenue, Average Revenue, and

Marginal Revenue for a Competitive Firm

• Total revenue is a straight line.

• The Demand curve is horizontal, indicating perfect price elasticity.

• Marginal revenue curve = demand curve, because the product price is constant.

• Average revenue curve = price = demand curve.

Short Run Profit Maximization

• Because the purely competitive firm is a price

taker, it can maximize its economic profit (or

minimize its loss) only by adjusting its output.

• In the short run, it can adjust its output only

through changes in the amount of variable

resources to achieve the output level that

maximizes its profit.


• Two approaches to determine the level of output

at which a competitive firm will realize maximum

profit or minimum loss.

• Total revenue and total cost approach

– Produce where TR-TC is greatest

• Marginal revenue and marginal cost approach

– Produce where MR=MC


• The competitive producer will ask three questions:

– Should the product be produced?

– If so, in what amount?

– What economic profit (loss) will be realized?

Total-Revenue Total-Cost Approach

• The goal of a competitive firm is to maximize

profit.

• This means that the firm will want to produce

the quantity that maximizes the difference between

total revenue (TR) and total cost (TC).


(1) Total Product (Output) (Q)

(2) Total Fixed Cost (TFC)

(3) Total Variable

Cost (TVC)

(4) Total Cost

(TC)

(5) Total Revenue

(TR)

(6) Profit (+) or Loss (-)

Price = $131

0 1 2 3 4 5 6 7 8 9

10

$100 100 100 100 100 100 100 100 100 100 100

$0 90

170 240 300 370 450 540 650 780 930

$100 190 270 340 400 470 550 640 750 880

1030

$0 131 262 393 524 655 786 917

1048 1179 1310

$-100 -59

-8 +53

+124 +185 +236 +277 +298 +299 +280

1 0 2 3 4 5 6 7 8 9 10 11 12 13 14

1 0 2 3 4 5 6 7 8 9 10 11 12 13 14

$1800

1700

1600

1500

1400

1300

1200

1100

1000

900

800

700

600

500

400

300

200

100

$500

400

300

200

100

To

tal

Re

ve

nu

e a

nd

To

tal

Co

st

To

tal

Eco

no

mic

P

rofi

t



Total Revenue, (TR)

Break-Even Point (Normal Profit)

Break-Even Point (Normal Profit)

Maximum Economic

Profit $299

Total Economic Profit

$299

P=$131

Total Cost, (TC)



• Total cost increases with output because more production requires more resources.

• The rate of increase in TC reflects the law of diminishing marginal returns.

• TR and TC are equal where the two curves intersect.

• Break-even point: an output at which a firm makes normal profit but not an economic profit.

• Any output within the 2 break-even points will yield an economic profit.

Marginal-Revenue Marginal-Cost

Approach

• The firm compare MR and MC

• MR: the additional revenue resulting from the

sale of an additional unit of output

• MC: the additional cost resulting from the sale

of an additional unit of output


Approach

• The firm's profits are maximized at the level of

output at which MR ( = P) = MC.

• Produce where MR = MC. The firm has no

incentive to produce either more or less output.


Approach

• If MR > MC, the production of an additional unit of output adds more to revenue than to costs. – In this case, a firm is expected to increase its level of

production to increase its profits.

• If MR < MC, the production of an additional unit of output costs more than the additional revenue generated by the sale of this unit. – In this case, firms can increase their profits by producing less.

• A profit-maximizing firm will produce more output when MR > MC and less output when MR < MC.

Marginal-Revenue Marginal-Cost Approach

(1) Total

Product (Output)

(2) Average

Fixed Cost

(AFC)

(3) Average Variable

Cost (AVC)

(4) Average

Total Cost

(ATC)

(6) Marginal Revenue

(MR)

(7) Profit (+) or Loss (-)

0 1 2 3 4 5 6 7 8 9

10

$100.00

50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00

$90.00

85.00 80.00 75.00 74.00 75.00 77.14 81.25 86.67 93.00

$190.00

135.00 113.33 100.00

94.00 91.67 91.43 93.75 97.78

103.00

$131

131 131 131 131 131 131 131 131 131

$-100 -59

-8 +53

+124 +185 +236 +277 +298 +299 +280

(5) Marginal

Cost (MC)

$90

80 70 60 70 80 90

110 131 150


Approach

• Each of the first 9 units adds to the firm’s profit and should be produced (MR > MC).

• The 10th unit should not be produced, it would add more to the cost ($150) than to revenue ($131).

• Profit = (profit per unit) x # of units

= (P – ATC) x Q = (131-97.78) x 9 = $299

• P = MC at the profit-maximizing output of 9 units.

• Note that the firm wants to maximize its total profit,

and not per-unit profit.

Co

st

an

d R

eve

nu

e

$200

150

100

50

0 1 2 3 4 5 6 7 8 9 10

Output

Economic Profit MR = P

MC MR = MC

AVC

ATC

P=$131

A=$97.78

Marginal-Revenue Marginal-Cost Approach

Short Run Loss Minimizing Case

Suppose that P < ATC. Since the firm is experiencing a loss, should it shut down?

• Stay in business if P > AVC.

• Shut down if P < AVC.


• Suppose the market price = $81 rather than $131.

– Should the firm still produced?

– If so, how much?

– And what will be the resulting profit or loss?

• Yes, 6 units, and a loss of $64.

• Why produce? This loss is less than the firm’s $100 of fixed costs, which is the $100 loss the firm would incur in the short run by closing down.


Lower the Price to $81 and Observe the Results!

Co

st

an

d R

eve

nu

e

$200

150

100

50

0 1 2 3 4 5 6 7 8 9 10

Output

Loss

Short Run Loss Minimizing Case: (AVC<P< ATC)

MR = P

MC

AVC

ATC

P=$81

A=$91.67

V = $75

Short Run Shut Down Case

• A shutdown refers to a short-run decision not to

produce anything during a specific period of

time because of current market conditions.

• Exit refers to a long-run decision to leave the

market.


Copyright © 2004 South-Western

MC

Quantity

ATC

AVC

0

Costs

Firm

shuts

down if

P < AVC

If P > AVC, firm will

continue to produce

in the short run.

If P > ATC, the firm

will continue to

produce at a profit.


• Suppose now that the market price = $71 rather

than $131.

• Should the firm still produced?

• No, because at every output the firm’s AVC > P.

• The smallest loss it can incur by producing is

greater than the $100 fixed cost.


Lower the Price Further to $71 and Observe the Results!

Co

st

an

d R

eve

nu

e

$200

150

100

50

0 1 2 3 4 5 6 7 8 9 10

Output

Short Run Shut Down Case: P < AVC

MR = P

MC

AVC

ATC

P=$71

Short-Run Shut Down Point

P < Minimum AVC $71 < $74

V = $74

Short-Run Supply Curve

Continuing the Same Example…

Supply Schedule of a Competitive Firm

Price Quantity Supplied

Maximum Profit (+) or Minimum Loss (-)

$151 131 111

91 81 71 61

10 9 8 7 6 0 0

$+480 +299 +138

-3 -64

-100 -100

The schedule shows the quantity a firm will produce at a variety of prices


From the table we can note that:

• The firm will not produce at price $61 or $71 because both are less than the $74 minimum AVC.

• The quantity supplied increases as price increases.

• The economic profit is higher at a higher price.



• The ATC, AVC, and MC are shown with several MR lines drawn at possible market prices.

• Price P1: is below the firm’s minimum AVC, so at this price the firm won’t operate at all (Qs = 0).

• Price P2: is just equal to the minimum AVC. The firm will supply Q2 units of output (where MR2 = MC). The firm would be indifferent as to shutting down or supplying Q2.


• Price P3: the firm will supply Q3 to minimize its short-run losses (AVC<P< ATC).

• Price P4: the firm will earn a normal profit but not an economic profit (MR = ATC). Total revenue will just cover total cost.

• Price P5: the firm will realize an economic profit b y producing and supplying Q5 units of output.


• The portion of the marginal-cost curve that lies

above average variable cost is the

competitive firm’s short-run supply curve.


Firms produce where MR=MC

P1

0

Co

st

an

d R

eve

nu

es (

Do

lla

rs)

Quantity Supplied

MR1

P2 MR2

P3 MR3

P4 MR4

P5 MR5

MC

AVC

ATC

Q2 Q3 Q4 Q5

This Price is Below AVC And Will Not Be Produced

a

b

c

d

e


P1

0

Co

st

an

d R

eve

nu

es (

Do

lla

rs)

Quantity Supplied

MR1

P2 MR2

P3 MR3

P4 MR4

P5 MR5

MC

AVC

ATC

Q2 Q3 Q4 Q5

a

b

c

d

e

MC Above AVC Becomes the Short-Run Supply Curve S

Examine the MC for the Competitive Firm

Break-even (Normal Profit) Point

Shut-Down Point (If P is Below)

Firms produce where MR=MC

Firm and Industry Supply

• Changes in firm supply:

1. Changes in the price of variable inputs or in

technology,

2. Will alter costs and shift the MC (it means

the short-run supply curve).

• For example, a wage increase would increase

MC and shift the supply curve: supply would

decrease.


• Changes in firm supply:

Technological progress that increases the

productivity of labor would reduce MC and shift

the MC or supply curve: an increase in supply.


• The industry (total) supply curve

– Sum of individual supply

– Market supply equals the sum of the

quantities supplied by the individual firms in

the market.

• Industry supply and demand

– Determine market price


Single Firm Industry p P

p P 0 0


Economic Profit

d

ATC

AVC

s = MC

$111 $111

D

S = ∑ MC’s

8 8000

Competitive firm must take the price that is Established by industry supply and demand

Long Run Profit Maximization

• Assumptions

– Entry and exit only: the only long-run adjustment is the entry or exit of firms.

– Identical costs: all firms in the industry have identical cost curves.

– Constant-cost industry: the entry and exit of firms does not affect resources prices.


• Goal of the analysis

– In the long run, the product price: P =

min ATC

– Entry eliminates profits

– Exit eliminates losses


• Long-run equilibrium

– In the long run: P=min ATC.

– Economic profit here = 0: Firms will enter or exit the market until profit is driven to zero.

– The industry is in equilibrium because there is no tendency for firms to enter or to leave.

– The market price is determined by market demand and supply.


• Long-run equilibrium

Long Run Profit Maximization • Entry Eliminates Profits (firm enter if P > ATC)

– market supply increases

– price declines

– profit declines until economic profit equals zero (and entry stops)

– Price is brought back down: P = min ATC

• Exit Eliminates Losses (firm exits if P < ATC)

– market supply decreases

– price rises

– losses decline until economic profit equals zero

– Price back up: P = min ATC


p P 0 0 100 90,000 80,000 100,000

Entry Eliminates Profits

ATC

MR

MC

$60

50

40

D1

S1

- An increase in demand temporarily raises price - Higher prices draw in new competitors - Increased supply returns price to equilibrium

D2

$60

50

40

S2


p P 0 0 100 90,000 80,000 100,000

Exit Eliminates Losses

ATC

MR

MC

$60

50

40

D3

S3

- A decrease in demand temporarily lowers price - Lower prices drive away some competitors - Decreased supply returns price to equilibrium

D1

$60

50

40

S1

Long-Run Supply Curve • What is the character of the long-run supply curve

of a competitive industry?

• The crucial factor here is the effect that changes in the number of firms in the industry will have on costs of the individual firms in the industry.

• Three cases:

– Constant-cost industry

– Increasing-cost industry

– Decreasing-cost industry

Long-Run Supply Curve • Constant-cost industry

– This means that entry and exit of firms does not affect resources prices.

– Entry/exit does not shift the long-run ATC

– The industry’s demand for resources is small in relation to the total demand for those resources.

– Constant resource price

– This is a special case

P

0 Q

Long-Run Supply Curve

Constant-Cost Industry

90,000 100,000 110,000

Q3 Q1 Q2

$50

P1

P2

P3

S Z1 Z2 Z3

D3 D1 D2

• The industry can expand or contract without significantly affecting resource prices and costs.

Long-Run Supply Curve • Increasing cost industry

– Most industries

– Long run ATC increases with expansion

– Long run ATC decreases with contraction

– Specialized resources

P

0 Q

Long-Run Supply Curve

Increasing-Cost Industry

90,000 100,000 110,000

Q3 Q1 Q2

$50 P1

S

Y1

Y2

Y3

D3

D1

D2

$40

$55 P2

P3

Long-Run Supply Curve • Decreasing cost industry

– Firms experience lower costs as their industry

expands.

– The personal computer industry is an

example.

– The supply of personal computers increased

by more than demand, and the price of

personal computers declined.

Pure Competition and Efficiency

• We need to understand the efficiency characteristics of the individual firms and the market.

• Whether the industry is an constant-cost industry or an increasing-cost industry, the final long-run equilibrium positions of all firms have the same basic efficiency characteristics.


• Two desirable efficiency properties:

– P = MC (marginal benefit = marginal

cost)

– P = minimum ATC


Productive efficiency P = minimum ATC

• In the long-run, pure competition forces firms to produce at the minimum ATC.

• It means that the minimum amount of resources will be used to produce any particular output.

• Goods produced in the least costly way.

Allocative efficiency P = MC


Maximum consumer and producer surplus

• Pure competition maximizes the sum of the “benefits surplus”

• Consumer surplus = net gain from trade received by consumers (MB > P for consumers up to the last unit consumed)

• Producer surplus = net gain received by producers (P > MC up to the last unit sold)


Dynamic adjustments • Many factors can cause MC not equal P:

– Consumer tastes,

– Resources supplies,

– Technology

• This will cause producers in either pursuing profit or avoiding loss, to reallocate resources until product supply is such that P one again equals MC.

• It means it will correct for any inefficiency in the allocation of resource.

Single Firm Market P

rice

Pri

ce

Quantity Quantity

0 0

Pure Competition and Efficiency:

Long-Run Equilibrium

P MR

D

S

Qe Qf

ATC

Productive Efficiency: Price = minimum ATC Allocative Efficiency: Price = MC

Pure competition has both in its long-run equilibrium

MC P=MC=Minimum ATC (Normal Profit)

P

Pure Competition and Efficiency: Long-Run Equilibrium

• P = MC = minimum ATC at Qf

• Qf indicates that the firm is achieving productive efficiency and allocative efficiency.

• It is using the most efficient technology, charging the lowest price, and producing the greatest output consistent with its costs.

• It is receiving only a normal profit, which is incorporated into the ATC curve.

• The sum of consumer surplus and producer surplus is maximized.

Why Do Competitive Firms Stay in Business If

They Make Zero Profit?

• Profit = total revenue - total cost.

• Total cost includes all the opportunity costs of

the firm.

• In the zero-profit equilibrium, the firm’s revenue

compensates the owners for the time and money

they expend to keep the business going.