Pure (perfect) Competition Please listen to the audio as you work through the slides.

Learning objectives Students should be able to thoroughly and completely explain: 1.The characteristics of pure competition 2.The 3 questions confronting the producer in pure competition. 3.The Total Revenue Total Cost approach to determining the profit maximizing output and price for the purely competitive firm. 4.The three features of the MR MC approach to determining the profit maximizing output and price for the purely competitive firm. 5.The following cases for the purely competitive firm in the short run: 1.Profit maximization 2.Loss minimization 3.Shut down 6.How is the short run supply curve derived 7.The characteristics of long run equilibrium of a purely competitive firm. 8.The implications for productive and allocative efficiency in pure competition Pure Competition

Issues 1.How do firms make decisions in various market structures? 2.How do firms determine the profit maximizing level of output in various market structures? 3.What is the impact of market structure on economic efficiency? Pure Competition

Market Structure Continuum Four Market Models Pure (or Perfect) Competition

Market Structure Continuum Pure Competition Four Market Models Imperfect Competition All Markets that are Not Purely Competitive

Market Structure Continuum Pure Competition Four Market Models Pure Monopoly One seller

Market Structure Continuum Pure Competition Pure Monopoly Four Market Models Monopolistic Competition Large # of sellers with differentiated (by brand or quality) products No perfect substitutes Such as: Books, clothing, furniture

Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Four Market Models Oligopoly A market dominated by a few sellers of Standardized or differentiated products

Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Pure Competition characteristics: 1. Very Large Numbers of buyers and sellers (small market shares) 2. Standardized Product – perfect substitutes (all the same) 3. “Price Takers” (individual producers and consumers have no control over price or quantity) 4. Free Entry and Exit – from the market

Demand as seen by a Purely Competitive Seller The individual seller faces a perfectly elastic demand curve Horizontal Demand Curve A firm cannot obtain a higher price by restricting its output, nor does it need to lower its price to increase its sales volume. The firm can sell all it wants at the equilibrium price. The Price Taker Role of the firm: 3 characteristics to know Total Revenue = price * quantity (TR=P) Average Revenue = price (AR=P) Marginal Revenue = price (MR=P)

Firm’s Demand Schedule (Average Revenue) Firm’s Revenue Data Pure Competition Price and Revenue $1179 Quantity Demanded (Sold) D = MR = AR TR PQDQD MR $ $ $ ] ] ] ] ] ] ] ] ] ] 9-11

Short-Run Profit Maximization Two Approaches to determine the profit maximizing level of output... First: Total-Revenue -Total Cost Approach The Decision Rule: Produce in the short-run if the firm can realize: 1- A profit (or) 2- A loss less than its fixed costs The Decision Process of the Firm: 3 Questions the firm must answer 1.Should the firm produce? 2.What quantity should be produced? 3.What profit or loss will be realized?

Total Revenue Total Cost Approach What is the profit maximizing level of output? (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 = $ $ $ $ $ $ Now Let’s Graph The Results…

$ $ Total Revenue and Total Cost Total Economic Profit Quantity Demanded (Sold) 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 Revenue Total Cost Approach

Short-Run Profit Maximization Two approaches to determine the profit maximizing level of output First: Total-Revenue -Total Cost Approach 3 Characteristics of MR=MC Rule: 1.The rule applies only if producing is preferred to shutting down 2.Rule applies to all market structures 3.Rule can be restated P=MC (price=MR) Second: Marginal-Revenue -Marginal Cost Approach Key Rule: MR = MC

Average Total Cost Total Product Average Fixed Cost Average Variable Cost Price = Marginal Revenue Total Economic Profit/Loss $ $ $ $ Marginal Revenue - Marginal Cost Approach $ Marginal Cost The same profit maximizing result!

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 (-) $ $ $ $ $ No Surprise - Now Let’s Graph It… Do You See Profit Maximization Now? (5) Marginal Cost (MC) $

Cost and Revenue $ Output Economic Profit MR = P MC MR = MC AVC ATC P=$131 A=$97.78 Marginal Revenue Marginal Cost Approach

Marginal Revenue - Marginal Cost Approach The Loss Minimization Case Lower the price from $131 to $81… The MR=MC rule still applies But the MR = MC point changes. Assume the cost structure remains the same.

$ Cost and Revenue MC MR AVC ATC Economic Loss $81.00 $91.67 Marginal Revenue - Marginal Cost Approach Loss Minimization Case - graphically

$ Cost and Revenue MC MR AVC ATC $71.00 Marginal Revenue - Marginal Cost Approach Short-Run Shut Down Case Minimum AVC is the Shut-Down Point Shut Down means a temporary decision not to produce due to current market conditions The firm would shut down if the revenue it would earn from producing is less than its variable costs of production.

Agenda Derive the short run supply curve Short – Run Competitive Equilibrium Profit Maximization in the long run Pure competition and Efficiency

Deriving the short-run supply curve for the Perfectly Competitive Firm Using the Marginal Cost Curve

Marginal Revenue - Marginal Cost Approach Marginal Cost & Short-Run Supply Price Quantity Supplied Maximum Profit (+) Or Minimum Loss (-) Observe the impact upon profitability as price is changed $ P5 91 P3 81 P2 71 P $ No production

Cost and Revenue, (dollars) MC MR 1 AVC ATC Marginal Revenue - Marginal Cost Approach Quantity Supplied MR 2 MR 3 MR 4 MR 5 P1P1 P2P2 P3P3 P4P4 P5P5 Q2Q2 Q3Q3 Q4Q4 Q5Q5 Marginal Cost & Short-Run Supply Do not Produce at price– Below AVC Break-even (Normal Profit) Point

Cost and Revenue, (dollars) MC MR 1 Marginal Revenue - Marginal Cost Approach Quantity Supplied MR 2 MR 3 MR 4 MR 5 P1P1 P2P2 P3P3 P4P4 P5P5 Q2Q2 Q3Q3 Q4Q4 Q5Q5 Marginal Cost & Short-Run Supply Yields the Short-Run Supply Curve Supply No Production if Price is Below AVC

Diminishing returns, production costs, and product supply 1.Because of the law of diminishing returns, marginal costs eventually rise as more units of output are produced. 2.Because marginal costs rise with output, a purely competitive firm must get successively higher prices to motivate it to produce additional units of output

Marginal Revenue - Marginal Cost Approach Marginal Cost & Short-Run Supply AVC 2 MC 2 Higher Costs Move the Supply Curve to the Left Cost and Revenue, (dollars) MC 1 AVC 1 Quantity Supplied S1S1 S2S2

Marginal Revenue - Marginal Cost Approach Marginal Cost & Short-Run Supply AVC 2 MC 2 Lower Costs Move the Supply Curve to the Right Cost and Revenue, (dollars) MC 1 AVC 1 Quantity Supplied S1S1 S2S2

Check Your Understanding 1.Explain the TR-TC approach. 2.Explain the MR-MC approach.

P Q S=MC AVC ATC 8 D P Q 8000 D S=  MCs Industry Competitive Firm (price taker) Economic Profit $111 Short-run Competitive Equilibrium The Competitive Firm “Takes” its Price from the Industry Equilibrium 1000 firms start

Output determination in pure competition in the short run Rules of thumb Should the firm produce? Yes, if price is equal to, or greater than, minimum AVC. This means that the firm is profitable or that its losses are less than it’s fixed costs. What quantity should this firm produce? Produce where MR (=P) = MC; there, profit is maximized or loss is minimized. Will production result in economic profit? Yes, if price exceeds ATC. No, if ATC exceeds price.

Profit Maximization in the Long Run Assumptions... Entry and Exit of firms is the only long run adjustment Identical Costs – all firms in industry face identical cost curves Constant-Cost Industry – entry and exit does not affect resource prices or the location of ATC curves of individual firms Goal of the Analysis Show that Price = Minimum ATC in the long run Long-Run Equilibrium: The Zero Economic Profit Model

Temporary profits and the reestablishment of long-run equilibrium S1S1 MC ATC P Q 100 P Q 100,000 Industry Firm (1000 firms) (price taker) $ $ Profit Maximization in the Long Run MR D1D1

An increase in demand increases economic profits MR D1D1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ Profit Maximization in the Long Run D2D2 Economic Profits S1S1

New competitors enter the industry. Supply increases. Prices fall. Economic profits fall. MR D1D1 MC ATC P Q 100 P Q 100,000 Industry Firm (1100 firms) (price taker) $ $ Profit Maximization in the Long Run D2D2 Zero Economic Profits S1S1 S2S2 110,000

Decreases in demand, lead to economic losses, and the reestablishment of long-run equilibrium S1S1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ Profit Maximization in the Long Run D1D1 MR

Demand falls. Equilibrium price falls. Firms suffer losses. MR D1D1 MC ATC P Q 100 P Q 100,000 Industry Firm (900 firms) (price taker) $ $ Profit Maximization in the Long Run D2D2 Economic Losses S1S1

MR D1D1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ Profit Maximization in the Long Run D2D2 Return to Zero Economic Profits S1S1 S3S3 Competitors with losses leave the industry. Supply falls. Prices return to zero economic profit levels. 90,000

Long-Run Supply in a Constant Cost Industry Constant Cost Industry Industry expansion or contraction does not affect resource prices. Long-run average costs are not changed for the individual firm. The industry represents only a small fraction of total resource demand. Result: Perfectly Elastic Long-Run Supply Graphically...

P Q =$50 S D1D1 Z1Z1 Q1Q1 D2D2 Z2Z2 Q2Q2 Q3Q3 D3D3 Z3Z3 100,000110,00090,000 Long-Run Supply in a Constant Cost Industry P1P2P3P1P2P3

P Q =$50 S D1D1 Z1Z1 Q1Q1 D2D2 Z2Z2 Q2Q2 Q3Q3 D3D3 Z3Z3 100,000110,00090,000 Long-Run Supply in a Constant Cost Industry P1P2P3P1P2P3 How does an increasing cost industry differ?

P Q $ S D1D1 Y1Y1 Q1Q1 D2D2 Y2Y2 Q2Q2 Q3Q3 D3D3 Y3Y3 100,000110,00090,000 Long-run Supply in an increasing cost industry A perfectly competitive industry with a positively-sloped long-run industry supply curve that results because expansion of the industry causes higher production cost and resource prices. An increasing-cost industry occurs because the entry of new firms, prompted by an increase in demand, causes the long-run average cost curve of each firm to shift upward. P1P2P3P1P2P3

Long-run supply in a decreasing cost industry A perfectly competitive industry with a negatively-sloped long- run industry supply curve that results because expansion of the industry causes lower production cost and resource prices. A decreasing-cost industry occurs because the entry of new firms, prompted by an increase in demand, causes the long-run average cost curve of each firm to shift downward.

P Q $ S D1D1 Y1Y1 Q1Q1 D2D2 Y2Y2 Q2Q2 Q3Q3 D3D3 Y3Y3 100,000110,00090,000 P1P2P3P1P2P3 What is the long- run competitive equilibrium? LONG-RUN SUPPLY IN AN INCREASING COST INDUSTRY

P MR Q MC ATC Quantity Price Price = MC = Minimum ATC (normal profit) Long-run equilibrium for a purely competitive firm

Pure Competition and Economic Efficiency Pure Competition yields Economic Efficiency Defined as: Productive Efficiency and Allocative Efficiency Price = Minimum ATCPrice = MC

Resources are efficiently allocated under pure competition

All Other Market Structures Relative to Economic Efficiency Under Allocation of Resources: Price > MC Or Over Allocation of Resources: Price < MC

For the Pure Competition Market Structure 1.List and explain the characteristics of pure competition 2.List and explain the 3 questions confronting the producer in pure competition? 3.Explain the Total Revenue Total Cost approach to determining the profit maximizing output and price for the purely competitive firm. 4.Explain long run equilibrium in pure competition 5.Explain efficiency in pure competition 6.Explain how the short run supply curve is derived

Cost of Production: 1.How is the long run ATC curve derived? 2.How might the presence of economies of scale or diseconomies of scale impact the shape of the LR ATC curve? 3.List and explain the Short Run Production Relationships 4.Explain the Law of Diminishing Returns

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