Profit Maximization in Profit Maximization in Pure CompetitionPure Competition

Perfect CompetitionPerfect Competition• Situation:Situation:• Yves and Zoe are neighboring farmers and both Yves and Zoe are neighboring farmers and both

grow organic tomatoes.grow organic tomatoes.• Both sell to the same grocery store chains that Both sell to the same grocery store chains that

carry organic foods.carry organic foods.• Do Yves and Zoe compete with each other?Do Yves and Zoe compete with each other?• YES!YES!• Should Yves try to stop Zoe from growing Should Yves try to stop Zoe from growing

tomatoes or should Yves and Zoe form an tomatoes or should Yves and Zoe form an agreement to grow less?agreement to grow less?

• NO!NO!

Perfect CompetitionPerfect Competition

• In the real world (real in Economic Class In the real world (real in Economic Class world), there are tons upon tons of organic world), there are tons upon tons of organic tomatoes farmers.tomatoes farmers.

• Yves and Zoe compete with each other but Yves and Zoe compete with each other but with all those other farmerswith all those other farmers

• If one of them produced more or less, there If one of them produced more or less, there would be no measurable effect on market would be no measurable effect on market prices!prices!

Perfect CompetitionPerfect Competition

• Yves and Zoe are price-taking producersYves and Zoe are price-taking producers– A producers whose actions have no effect on the A producers whose actions have no effect on the

market price of the good or service it sellsmarket price of the good or service it sells

• Yves and Zoe are price-taking producers Yves and Zoe are price-taking producers because their actions cannot affect the because their actions cannot affect the market price of the good or service they sellmarket price of the good or service they sell

• When there is enough competition (when When there is enough competition (when competition is “perfect”) every producer is a competition is “perfect”) every producer is a price-takerprice-taker

Perfect CompetitionPerfect Competition

• Now, what about consumers?Now, what about consumers?• A consumer whose actions have no effect A consumer whose actions have no effect

on the market price of the good or on the market price of the good or service he buys is a price-taking service he buys is a price-taking consumer.consumer.

• The market price is unaffected by how The market price is unaffected by how much or how little of the good the much or how little of the good the consumer buysconsumer buys

Defining Perfect CompetitionDefining Perfect Competition• In a perfectly competitive market, all market In a perfectly competitive market, all market

participants, both consumers and producers, participants, both consumers and producers, are price-takers.are price-takers.– Neither consumption decisions by individual Neither consumption decisions by individual

consumers nor production decisions by individual consumers nor production decisions by individual producers affect the market price of the goodproducers affect the market price of the good

• The supply and demand model is a model of The supply and demand model is a model of a perfectly competitive market.a perfectly competitive market.– Depends on the assumption that no individual Depends on the assumption that no individual

buyer or seller of a good believes it is possible to buyer or seller of a good believes it is possible to individually affect the price at which he or she individually affect the price at which he or she can buy or sell the goodcan buy or sell the good

Defining Perfect CompetitionDefining Perfect Competition

• General rule: consumers are price-takersGeneral rule: consumers are price-takers• Industry in which producers are price-takers Industry in which producers are price-takers

is called a perfectly competitive industryis called a perfectly competitive industry– This is an industry in which producers are price-This is an industry in which producers are price-

takerstakers

• When are all producers price-takers?When are all producers price-takers?• There are two necessary conditions!There are two necessary conditions!

Two Necessary Conditions for Perfect Two Necessary Conditions for Perfect CompetitionCompetition

• 1. Must contain many producers but 1. Must contain many producers but none of which whom have a large none of which whom have a large market sharemarket share

• 2. An industry can be perfectly 2. An industry can be perfectly competitive only if consumers regard the competitive only if consumers regard the products of all producers as equivalentproducts of all producers as equivalent

Two Necessary Conditions for Perfect Two Necessary Conditions for Perfect CompetitionCompetition

• Example for explanation is the market for major Example for explanation is the market for major grains, like wheat and corngrains, like wheat and corn

• The market is perfectly competitive – individual The market is perfectly competitive – individual wheat and corn farmers, as well as individual wheat and corn farmers, as well as individual buyers of wheat and corn, take market prices as buyers of wheat and corn, take market prices as givengiven

• The markets for some of the good items make The markets for some of the good items make from these grains – breakfast cereals – are by no from these grains – breakfast cereals – are by no mean perfectly competitivemean perfectly competitive

• There is intense competition among cereal There is intense competition among cereal brands, but NOT PERFECT COMPETITIONbrands, but NOT PERFECT COMPETITION

1. Must contain many producers but none of 1. Must contain many producers but none of which whom have a large market sharewhich whom have a large market share

• A producer’s market share is the fraction of the A producer’s market share is the fraction of the total industry output accounted for by that total industry output accounted for by that producer’s outputproducer’s output

• The distribution of the market share constitutes The distribution of the market share constitutes a major difference between the grain industry a major difference between the grain industry and the breakfast cereal industryand the breakfast cereal industry– Thousands of wheat producers but four producers Thousands of wheat producers but four producers

dominate the breakfast cereal industry (Kellogg’s – dominate the breakfast cereal industry (Kellogg’s – hold 1/3 of the market --, General Mills, Post, and hold 1/3 of the market --, General Mills, Post, and Quaker Foods)Quaker Foods)

– The breakfast producers know their actions influence The breakfast producers know their actions influence market pricesmarket prices

2. An industry can be perfectly competitive 2. An industry can be perfectly competitive only if consumers regard the products of all only if consumers regard the products of all

producers as equivalentproducers as equivalent

• Not true in the case of the breakfast cereal market –Not true in the case of the breakfast cereal market –consumers don’t consider Cap’n Crunch to be a good consumers don’t consider Cap’n Crunch to be a good substitute for Wheatiessubstitute for Wheaties– Maker of Wheaties has some ability to increase its price Maker of Wheaties has some ability to increase its price

without fear that it will lose all its customers to the without fear that it will lose all its customers to the maker of Cap’n Crunchmaker of Cap’n Crunch

• Standardized Product is when a product that Standardized Product is when a product that consumers regard as the same good even when it consumers regard as the same good even when it comes from a different producers, sometimes known comes from a different producers, sometimes known as a commodity (something that is indistinguishable)as a commodity (something that is indistinguishable)– Example: Corn, Wheat, Pencils, Pen, lined paper, copy Example: Corn, Wheat, Pencils, Pen, lined paper, copy

paperpaper

2. An industry can be perfectly competitive 2. An industry can be perfectly competitive only if consumers regard the products of all only if consumers regard the products of all

producers as equivalentproducers as equivalent

• With wheat being a standardized product, With wheat being a standardized product, consumers regard the output of one wheat consumers regard the output of one wheat producer as a perfect substitute for that of producer as a perfect substitute for that of another produceranother producer

• BUT….one farmer cannot increase the price for BUT….one farmer cannot increase the price for his wheat without losing all sales to other wheat his wheat without losing all sales to other wheat farmersfarmers

→ → second necessary condition for a competitive second necessary condition for a competitive industry is that the industry output is a industry is that the industry output is a standardized productstandardized product

Free Entry and ExitFree Entry and Exit

• Most perfectly competitive industries are also Most perfectly competitive industries are also characterized by one more feature: it is easy for characterized by one more feature: it is easy for new firms to enter the industry and for firms new firms to enter the industry and for firms already in the industry to leavealready in the industry to leave

• No obstacles in the form of government No obstacles in the form of government regulations or limited access to key resources regulations or limited access to key resources prevent new producers from entering the prevent new producers from entering the marketmarket

• No additional costs are associated with shutting No additional costs are associated with shutting down a company and leaving the industrydown a company and leaving the industry

Free Entry and ExitFree Entry and Exit

• Free Entry and Exit in an industry is when new Free Entry and Exit in an industry is when new producers can easily enter into an industry and producers can easily enter into an industry and existing producers can easily leave that industryexisting producers can easily leave that industry

• This is a key factor in most competitive This is a key factor in most competitive industriesindustries

• It make sure that the numbers of producers in It make sure that the numbers of producers in an industry can adjust to changing market an industry can adjust to changing market conditionsconditions

• Also ensures that producers in an industry Also ensures that producers in an industry cannot act to keep other firms out!cannot act to keep other firms out!