PureCompetition

Chapter 9

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives

• The four basic market models• Conditions for pure competition• Profit maximization for

competitive firms• The competitive firm supply

curve• Industry entry and exit• Industry cost structure• Economic efficiency

9-2

Four Market Models

• Pure competition• Pure monopoly• Monopolistic competition• Oligopoly

Market Structure Continuum

PureCompetition

MonopolisticCompetition Oligopoly

PureMonopoly

Imperfect Competition

9-3

Pure Competition

• Although instances of “pure competition” are rare in the real world, it serves as a model for the other three types of market models

• Consists of very large numbers of firms

• Standardized product; one producer’s product looks pretty much like everyone else’s–Agricultural products are a classic

example; raising corn9-4

Pure Competition

• Firms in pure competition are“Price takers”–There are so many sellers that no

single seller can affect the price by its decision alone

– Individual firms must accept the market price

• Firms can freely enter and exit from pure competition; there are no barriers to becoming a farmer and raising corn

Pure Competition from the viewpointof a competitive seller

• The demand curve for the firm is perfectly elastic (horizontal)– A horizontal demand curve means that the firm can

sell as much product as it wants but only at a fixed price (because it cannot affect price

– However, as you will see later, the demand curve for the industry is not perfectly elastic

Some Definitions:• Average revenue is the price per unit for each firm in

pure competition• Total revenue is the price multiplied by the quantity

sold• Marginal revenue is the change in total revenue and

will also equal the unit price in conditions of pure competition.

Firm’sDemandSchedule(AverageRevenue)

Firm’sRevenue

Data

Pure Competition

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

]]]]]]]]]]

9-7

Short Run Profit MaximizationThe Firm’s Viewpoint

• The market price for the firm is fixed– In the short run, the firm has a fixed plant

(limited acreage)– Since the firm cannot change the price, it can

only increase total revenue by producing more of the product

– Profit can be defined as the difference between total costs and total revenue

• Three questions a firm will face– Should the product be produced?– If so, in what amount?– What economic profit (loss) will be realized?;

how to maximize profit9-8

Profit Maximization

Two approaches• Total revenue – total cost approach

–Firms should produce if the difference between total revenue and total cost is profitable; i.e. the greatest difference• In the short run, the firm should produce

that output at which it maximizes its profits or minimizes its losses

• The profit or loss can be established by subtracting total cost from total revenue at each output level

9-9

Profit Maximization

• Firms operating at the profit maximization level may still experiences overall losses in profits

• They are then faced with the decision as to whether to continue production or go out of business

– In the short run, firms have fixed costs which are unavoidable and variable costs attributable to producing more of a product

– if the firm’s losses exceeds its fixed costs, the firm should not produce but should shut down

• By shutting down, its losses will just equal those fixed costs (there will be no variable costs because the firm is not producing

Profit Maximization

• Marginal Revenue – Marginal Cost approach– The MR=MC rule states that firms will maximize

profits or minimize losses by producing at the point at which marginal revenue equals marginal cost in the short run

• Three features of the MR=MC rule• It assumes that marginal revenue must be equal

to or exceed the minimum average variable cost or the firm will shut down

• The rule works in any type of industry, not just pure competition

• In pure competition, price = MR. Then, it follows that firms should produce that output where p = MC because P = MR

Total Revenue Total Cost Approach

(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?9-12

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

Quantity Demanded (Sold)

Quantity Demanded (Sold)

Total Revenue, (TR)

Break-Even Point(Normal Profit)

Break-Even Point(Normal Profit)

MaximumEconomic

Profit$299

Total EconomicProfit

$299

P=$131

Total Cost,(TC)

Total Revenue Total Cost Approach

9-13

Marginal Revenue Marginal Cost Approach

(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

9-14

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

Marginal Revenue Marginal Cost Approach

9-15

Short Run Profit Maximization

• Maximum profit at point where MR (=P) = MC

• If the firm suffers loss at that point, should it still produce?

• Yes if loss is less than fixed cost–Cover variable cost of production

• Shut down if loss greater than fixed cost

• Produce if P > min AVC9-16

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

Short Run Loss Minimizing Case

MR = P

MC

AVCATC

P=$81

A=$91.67

V = $75

9-17

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

Short Run Shut Down Case

MR = P

MC

AVC

ATC

P=$71

Short-Run Shut Down Point

P < Minimum AVC$71 < $74

V = $74

9-18

Short-Run Supply Curve

Continuing the Same 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

9-19

Short-Run Supply Curve

Firms produce where MR=MC

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 AVCAnd Will Not Be Produced

ab

c

d

e

9-20

Short-Run Supply Curve

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

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)

Firms produce where MR=MC

9-21

Firm and Industry Supply

Changes in the price of variable inputs such as labor costs or technology can alter prices– Increases or decreases in prices of resources

can shift the marginal cost in or out• The industry (total) supply curve

– Sum of the supply by all individual firms• Industry supply and demand

– Determine market price– The demand curve for the industry is not

perfectly elastic

9-22

Single Firm Industryp P

p P0 0

Firm and Industry 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

9-23

Long Run Profit Maximization

• Assumptions– Entry and exit of firms into the industry

are the only long-run adjustments– Firms in the industry have identical

cost curves– The industry is a constant-cost

industry, which means that the entry and exit of firms will not affect resource prices

• Goal of the analysis– In the long run, P = min ATC– Entry eliminates profits– Exit eliminates losses

9-24

Single Firm Industryp P

p P0 0100 90,00080,000 100,000

Entry Eliminates Profits

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

9-25

Single Firm Industryp P

p P0 0100 90,00080,000 100,000

Exit Eliminates Losses

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

9-26

Long Run Supply• Constant cost industry

– In a constant cost industry, the entry or exit of firms does not change the price of resources, and therefore, does not change production costs• This could occur when the resource used in the

constant-cost industry is only a small amount of the total resource available

– If production costs do not change, then neither does the Long Run ATC curve

– The long run supply curve of a constant-cost industry if perfectly elastic (horizontal)

– This means that costs are constant; if demand increases, there is no increased costs to produce more of anything 9-27

Long Run Supply

• Increasing cost industry– Most industries are increasing cost industries– LR ATC increases with the entrance of new firms

because the resources are scarce, and demand for them by the firms drives up the price

– This is particularly true for resources that are not freely available (may be difficult to process) and supply cannot keep up with demand

– Because each firm experiences increasing costs with increased production, their ATC tends to shift upward

– Because of the increased costs of production, the industry will require higher prices and the supply curve is upward sloping

Long Run Supply

• Decreasing Cost Industries– For some industries such as those producing

computer chips, costs actually decreased as technology improved

– The great demand for chips has allowed producers to enjoy great benefits of economies of scale

– Because costs decreased, the supply curve for decreasing cost industries is downward sloping

P

0 Q

Long-Run Supply Curve

Constant-Cost Industry

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

$50

P1

P2

P3

SZ1 Z2Z3

D3 D1 D2

9-30

P

0 Q

Long-Run Supply Curve

Increasing-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?9-31

Pure Competition and Efficiency

• Productive efficiencyP = minimum ATC

• Allocative efficiencyP = MC

• Maximum consumer and producer surplus

• Dynamic adjustments• “Invisible Hand” revisited

9-32

Single Firm MarketP

rice

Pri

ce

Quantity Quantity

0 0

Long-Run Equilibrium

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

9-33

Key Terms• pure competition• pure monopoly• monopolistic

competition• oligopoly• imperfect

competition• price taker• average revenue• total revenue• marginal revenue• break-even point• MR=MC rule• 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

9-34

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PureMonopoly

9-35