Copyright 2008 The McGraw-Hill Companies 21-1 21 Pure Competition

Copyright 2008 The McGraw-Hill Companies21-1

21PureCompetition


Chapter Objectives• Names and Main Characteristics of

the Four Basic Market Models• Conditions for Perfect Competition• How Do Purely Competitive Firms

Maximize Profits or Minimize Losses

• How Industry Entry and Exit Create Economic Efficiency

• Differences Between Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries


Market structure

• In past chapters we have discussed demand, revenue, and production costs: would now like to ask, what amount of output should a firm produce and what price should they charge?

• Answer will depend very much on the structure of the industry the firm operates in.

• We have 4 models of industry structure.


Four Market Models• Pure Competition

• Pure Monopoly

• Monopolistic Competition

• Oligopoly

Market Structure Continuum

PureCompetition

MonopolisticCompetition Oligopoly

PureMonopoly

Imperfect Competition


Characteristics of Pure Competition

• Very Large Numbers of sellers and buyers

• Standardized or homogenous Product

• Firm becomes a “Price Taker”• Free Entry and Exit• Some books add in perfect

information also (then called perfect competition)

Graphically…


The Market and the firm in Perfect Competition

The Market

PSD

Individual firm

P

P=MR

6


Why does a Perfectly Competitive firm face a horizontal demand curve?

• Because it can sell all it brings to market at the market price, therefore P always equals MR: thus the horizontal price line equals MR to the firm, and is effectively like a demand curve to the firm.


The firm in Perfect CompetitionThe firm in Perfect Competition

8

P

Q1

P = MR


Profit maximization in the short run

• Since the firm in pure competition does not control price, the question becomes what output should be produced in order to maximize profits?

• Two approaches:• 1. Total revenue, total cost approach: find the

output at which TR exceeds TC by the greatest possible amount.

• 2. Marginal revenue, marginal cost approach: find the output at which MR equals MC.

• Mostly we will stress the latter appoach.


Firm’sDemandSchedule(AverageRevenue)

Firm’sRevenue

Data

Pure Competition: TR, TC approach

Pri

ce a

nd

Rev

enu

e

2 4 6 8 10 12

131

262

393

524

655

786

917

1048

$1179

Quantity Demanded (Sold)

D = MR = AR

TR

P QDTR MR

$131131131131131131131131131131131

0123456789

10

$0131262393524655786917

104811791310

$131131131131131131131131131131

]]]]]]]]]]


Total Revenue-Total Cost Approach

Profit Maximization in the Short Run

(1)Total Product(Output) (Q)

(2)Total FixedCost (TFC)

(3)Total Variable

Cost (TVC)

(4)Total Cost

(TC)

(5)Total Revenue

(TR)

(6)Profit (+)

or Loss (-)

Price = $131

0123456789

10

$100100100100100100100100100100100

$090

170240300370450540650780930

$100190270340400470550640750880

1030

$0131262393524655786917

104811791310

$-100-59-8

+53+124+185+236+277+298+299+280

Now Let’s Graph The Results…Do You See Profit Maximization?


Total Revenue-Total Cost Approach


10 2 3 4 5 6 7 8 9 10 11 1213 14

10 2 3 4 5 6 7 8 9 10 11 1213 14

$180017001600150014001300120011001000

900800700600500400300200100

$500400300200100

To

tal

Re

ven

ue

and

To

tal

Co

stT

ota

l E

con

om

icP

rofi

t



Total Revenue, (TR)

Break-Even Point(Normal Profit)

Break-Even Point(Normal Profit)

MaximumEconomic

Profit$299

Total EconomicProfit

$299

P=$131

Total Cost,(TC)

W 21.1

G 21.1


Profit Maximization in the Short Run: MR = MC approach

• Firm should produce an output where MR=MC. Why?

• (Note also that this rule can be used for all market structures.)


MC

The firm in Perfect CompetitionThe firm in Perfect Competition

14

P

Q1

P = MR


Profit Maximization in the Short Run: MR = MC approach

• If the firm produced less than Q1, then MR would exceed MC: could increase profit by expanding ouput.

• If the firm more than than Q1, then MC would exceed MR: could increase profit by contracting ouput.

• The combination of these leads to the MR=MC rule.• Is the firm actually making a profit, a loss, or breaking

even? Need to add the ATC curve to the graph in order to show this.


ATC

MC

Positive profits in Perfect CompetitionPositive profits in Perfect Competition

16

P

Q1

P = MR

P > ATC

Profit


ATC

MC

Losses in Perfect CompetitionLosses in Perfect Competition

17

P

Q1

P = MR

P < ATC

Losses


ATC

MC

Zero Profits in Perfect CompetitionZero Profits in Perfect Competition

18

P

Q1

P = MR

P = ATC


Marginal Revenue-Marginal Cost ApproachMR = MC Rule


(1)Total

Product(Output)

(2)Average

FixedCost(AFC)

(3)AverageVariable

Cost(AVC)

(4)Average

TotalCost(ATC)

(6)MarginalRevenue

(MR)

(7)Profit (+)

or Loss (-)

0123456789

10

$100.0050.0033.3325.0020.0016.6714.2912.5011.1110.00

$90.0085.0080.0075.0074.0075.0077.1481.2586.6793.00

$190.00135.00113.33100.00

94.0091.6791.4393.7597.78

103.00

$131131131131131131131131131131

$-100-59-8

+53+124+185+236+277+298+299+280

No Surprise - Now Let’s Graph It…Do You See Profit Maximization Now?

(5)Marginal

Cost(MC)

$90807060708090

110130150


Co

st a

nd

Rev

enu

e$200

150

100

50

01 2 3 4 5 6 7 8 9 10

Output

Economic Profit



MR = P

MCMR = MC

AVC

ATC

P=$131

A=$97.78

W 21.2


Lower the Price to $81 andObserve the Results!

Co

st a

nd

Rev

enu

e$200

150

100

50

01 2 3 4 5 6 7 8 9 10

Output

Loss



MR = P

MC

AVCATC

Loss Minimizing Case

P=$81

A=$91.67

V = $75


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

Co

st a

nd

Rev

enu

e$200

150

100

50

01 2 3 4 5 6 7 8 9 10

Output



MR = P

MC

AVC

ATC

Short-Run Shut Down Case

P=$71Short-Run

Shut Down PointP < Minimum AVC

$71 < $74

V = $74


Marginal Cost and Short-Run Supply

Continuing the Same Numeric Example…

Supply Schedule of a Competitive Firm

PriceQuantitySupplied

Maximum Profit (+)or Minimum Loss (-)

$151131111

91817161

10987600

$+480+299+138

-3-64

-100-100

The Schedule Shows the Quantity a FirmWill Produce at a Variety of Prices and Results



Generalizing the MR=MC Relationship and its Use

P1

0

Co

st a

nd

Rev

enu

es (

Do

llars

)

Quantity Supplied

MR1

P2 MR2

P3 MR3

P4 MR4

P5 MR5

MC

AVC

ATC

Q2 Q3 Q4 Q5

This Price is Below AVCNo output should Be Produced

ab

c

d

e



Generalizing the MR=MC Relationship and its Use

P1

0

Co

st a

nd

Rev

enu

es (

Do

llars

)

Quantity Supplied

MR1

P2 MR2

P3 MR3

P4 MR4

P5 MR5

MC

AVC

ATC

Q2 Q3 Q4 Q5

This Price is Below AVCNo output should Be Produced

ab

c

d

e

MC Above AVC Becomesthe Short-Run Supply Curve S

Examine the MC for the Competitive Firm

Break-even(Normal Profit) Point

Shut-Down Point (If P is Below)


Why is a firm’s MC curve above its AVC curve its Supply Curve?

• Because it always produces where

MR = MC, except when price is below AVC


Why don’t we include the MC curve below its AVC curve as a part of its

Supply Curve?

• Because below the AVC the firm will close down


What is the Market’s Supply Curve?

• It is the aggregation or sum of the short run MC curves of the firm’s in the market


Single Firm Industryp P

p P0 0

Changes in Supply

EconomicProfit

d

ATC

AVC

s = MC

$111 $111

D

S = ∑ MC’s

8 8000

Competitive Firm Must Take the Price that isEstablished By Industry Supply and Demand

W 21.3


Profit Maximization in the Long Run

• Assumptions–Entry and Exit Only–Identical Costs–Constant-Cost Industry

• Goal of the Analysis• Long-Run Equilibrium

–Entry Eliminates Profits–Exit Eliminates Losses


The Long Run adjustments in Perfect Competition

The Market Individual firm 31

PSD P

P=MR

MC

ATC

D1

S1

P

P1

Q Q1


Explanation of long run adjustments

Start at price P, typical firm making zero profits

Suppose demand increases to D1

Price rises to P1 Typical firm making positive profits What happens in the long run? Assuming perfect information and free

entry, new firms enter the market Supply shifts right until profits eliminated Price comes down—but how far depends

on whether costs are affected


Long Run, continued

Constant cost industry: no change in costs as new firms enter the market, price returns to P, original price

Increasing cost industry: all firms experience rising costs as new firms enter the market, final price will be higher than original price P

Decreasing cost industry: all firms experience lower costs as new firms enter the market, final price will be lower than original price



p P0 0100 90,00080,000 100,000

Supply Readjustment

ATC

MR

MC

$60

50

40

D1

S1

An Increase in Demand Temporarily Raises PriceHigher Prices Draw in New CompetitorsIncreased Supply Returns Price to Equilibrium

D2

$60

50

40

S2



p P0 0100 90,00080,000 100,000

Supply Readjustment

ATC

MR

MC

$60

50

40

D3

S3

A Decrease in Demand Temporarily Lowers PriceLower Prices Drive Away Some CompetitorsDecreased Supply Returns Price to Equilibrium

D1

$60

50

40

S1


P

0 Q

Long-Run Supply CurveConstant-Cost Industry

90,000 100,000 110,000Q3 Q1 Q2

$50

P1

P2

P3

SZ1 Z2Z3

D3 D1 D2


P

0 Q

Long-Run Supply CurveIncreasing-Cost Industry

90,000 100,000 110,000Q3 Q1 Q2

$50P1

S

Y1

Y2

Y3

D3

D1

D2

$40

$55P2

P3

How Would a Decreasing-Cost Industry Look?


Pure Competition and Efficiency

• Productive EfficiencyP = Minimum ATC

• Allocative EfficiencyP = MC

• Maximum Consumer and Producer Surplus

• Dynamic Adjustments• “Invisible Hand” Revisited

O 21.1


Single Firm MarketP

rice

Pri

ce

Quantity Quantity

0 0

Long-Run EquilibriumCompetitive Firm and Market

P MR

D

S

QeQf

ATC

Productive Efficiency: Price = Minimum ATCAllocative Efficiency: Price = MCPure Competition Has Both in

Its Long-Run Equilibrium

MCP=MC=MinimumATC (Normal Profit)

P


Efficiency Gains From Entry:

• Competitive Model Predicts Lower Price and Greater Output With Increased Efficiency When New Producers Enter Market

• Example is Patented Drugs lose their patent protection

• Patents Enable Greater Profits in Support of R&D and Accelerated Cost Recovery

• After Patent Period Generics Enter Market• Profits Decrease and Quantities Increase• Combined Consumer and Producer

Surpluses Increase

Last

Word

The Case of Generic Drugs


Pri

ce

Quantity

Efficiency Gains From Entry:Last

Word

The Case of Generic Drugs

P1

P2

D

S

Q1 Q2

f

a

d

cb

• As Price Decreases to f,

• Consumer Surplus abcIncreases to adf

• Producer and ConsumerSurplus is MaximizedTogether as Shown bythe Gray Triangle

Initial Patent Price

Results: Greater Quantity at Lower Pricesas Predicted by the Competitive Model

New Producers Enter Market


Key Terms• pure competition• pure monopoly• monopolistic com

petition• oligopoly• imperfect

competition• price taker• average revenue• total revenue• marginal revenue• break-even point• MR=MC• short-run supply

curve

• long-run supply curve

• constant-cost industry

• increasing-cost industry

• decreasing-cost industry

• productive efficiency

• allocative efficiency

• consumer surplus• producer surplus

Documents

Copyright 2008 The McGraw-Hill Companies 21-1 21 Pure Competition