Unit 3: Theory of the Firm Part 1 Pure Competition Unit 3: Theory of the Firm Part 1

Four Market Models Pure competition Pure monopoly Monopolistc competition Oligopoly

Pure Competition Very large number of firms Firms produce standardized products New firms can enter or exit the industry very easily

Pure Monopoly One firm is the sole seller of a good or service Entry of additional firms is blocked One firm = entire industry

Monopolistic Competition Relatively large number of sellers Firms produce differentiated products Nonprice compétition – firms attempt to distinguish its product from competitors on the basis of attributes like design and quality Entry and exit is easy

Oligopoly Few sellers of a standardized or differentiated product Each firm is affected by the decisions of its rivals and must take those decisions into account in detemining price and output

The Four Market Models Lorem ipsum dolor sit amet, consectetuer adipiscing elit. Vivamus et magna. Fusce sed sem sed magna suscipit egestas.

Pure Competition All other market models are called imperfect competition Relatively rare in the real world Provide insight into several markets Agricultural goods, fish products, forex, basic metals, and stocks Very large numbers, standardized product, free entry or exit

Price Takers Individual firms do not exert control over the product price Every firm sells a small fraction of total (identical) output Changing individual firm output will not influence the market At the mercy of the market Cannot change market price, only adjust to it

Demand Demand schedule faced by an individual firm in a purely competitive industry is perfectly elastic at the market price

Market Demand Market demand is a downsloping curve An entire industry can affect price by changing total industry output

Average, Total, and Marginal Revenue The demand schedule is also its average revenue schedule. Total revenue = Price (or average revenue) * Quantity Marginal revenue – the change in total revenue resulting from selling one additional unit of output In pure competition, marginal revenue = price = average revenue

Average, Total, and Marginal Revenue

Profit Maximization in the Short Run Since purely compeitive firms are price takers, they can maximize economic profit (or minimize loss) only by adjusting output In the short run, the firm has a fixed plant Can only change the amount of variable resources it uses PC will adjust their varibale resources to acheive the output level that maximizes its profit

Maximizing Profit Two ways to determine the profit maximizing level of output for a competitive firm Compare TR and TC or compare MR and MC Both methods work regardless of market structure

Total-Revenue-Total-Cost Approach Given a market price Should we produce the product? If so, in what amount? What economic profit or loss will the we realize? Break even point – TR=TC Firm makes a normal profit but not an economic profit

TR/TC Approach Example

TR/TC Approach Graph

Marginal-Revenue-Marginal-Cost Approach Firm compares the amounts that each additional unit of output would add to TR and TC If assume producing is preferable to shutting down, a firm will produce an additional unit as long as MR > MC

MR=MC Rule In the short run, the firm will maximize profit or minimize loss by producing the output at which MR = MC If the optimal level is fractional, the firm will produce the last whole amount at which MR>MC Only applies if producing is preferable to shutting down If MR is not > AVC the firm will shut down Rule applies to all market structures In a purely competitive market MR=P=MC

Profit Maximizing Case

Profit Maximizing Case Graph

Loss Minimizing Case In the short run, a firm will continue to produce at a loss as long as it can cover its fixed costs Wherever P exceeds average variable cost but is less than Average Total costs, the firm can pay part, but not all of its fixed costs by producing Loss is minimized at MR=MC (P=MC)

Loss-Minimizing Case

Loss Minimizing Case Graph

Shut Down Case

Shut Down Case Graph

Marginal Cost and Short-Run Supply

Diminishing Returns, Productions Costs and Product Supply Because of the law of diminishing returns, marginal costs eventually rise as more units of output are produced. A purely competitive firm must get successively higher prices to motivate it to produce additional units of output

Firm and Industry: Equilibrium Price For a competitive firm, the short-run supply curve is drawn by applying the MR=(P=)MC rule Market equilibrium price is the price at which the total quantity supplied of the product equals the total quantity demanded.

Market Price and Profit Graph

Firm and Market S/D

Market Price and Profit Market equilibrium is where total quantity demand = total quantity supplied Does total revenue exceed total cost? TR-TC= economic profit of each firm Product price – ATC = economic profit of each firm Remember, individual firms are price takers The supply plans of the competitive producers as a group is a determinant of product price

PC output Determination in the Short-Run

Profit Maximization in the Long Run Assumptions: The only long-run adjustment is the entry or exit of firms Ignore all short-run adjustments Identitcal costs Constant cost industry Two basic facts Firms seek profits and shun losses Under pure competition, firms are free to enter and leave an industry

Long-Run Equilibrium For a single firm, long –run equilibrium occurs: MR=MC=P P= minimum ATC No firms have the incentive to enter or exit Industry in equilibrium (at rest)

Entry Eliminates Economic Profit

Exit Eliminates Economic Losses

Long-Run Supply Curve for a Constant Cost Industry Industry expansion or contraction will not affect resource prices or production costs Entry and exit does not shift the long-run ATC curves of individual firms Industry demand for resources is small relative to the amount of resources available Long run supply curve is perfectly elastic

LR Supply Curve – Constant Cost

Long-Run Supply: Increasing Cost Industry Firms’ ATC curves shift upwards as the indsutry expands (downwards when it contracts) Entry of new firms will increase resource prices Specialized inputs or limited supply

Long-Run Supply for Increasing Cost Industry

Long-Run Supply: Decreasing Cost Industry Firms experience lower costs as the industry expands Personal computers Economies of scale Downsloping long-run supply curve

Pure Competition and Effficiency

Productive Efficiency P= Minimum ATC Goods must be produced in the least costly way Consumers benefit by paying the lowest product price possible under prevailing technology and cost conditions

Allocative Efficiency P= MC Resources are aportioned among firms and industries to yield the mix of products and services that is most wanted by society Cannot simply alter the combination of goods and services and achieve any net gains for society The price of any product is society’s measure of the relative worth of additional unit (P=MB) MC of a good is the opportunity cost of another good sacrificed

Maximum Consumer and Producer Surplus At market equilibrium both consumer and producer surplus are maximized Any output beyond Qe would lead to a deadweight loss Short run economic profits and losses encourage entry and exit allowing the industry to adjust