PURE CompetITion

4 Types of Basic Market Models Pure Competition Pure Monopoly Monopolistic Competition Oligopoly

Pure Competition Characteristics: Rare in the real world But…helps analyze industries which are similar to pure competition Many sellers means that no one seller has an impact on price by its decisions alone Products are standardized Firms are “price-takers” – must accept the market price Firms can freely enter and exit the market

Analyzing Pure Competition To examine: Demand from the seller’s viewpoint Competitive producer responses to market price in the short run Long run adjustments in a competitive industry The efficiency of competitive markets

Demand (as Competitive Seller) Individual firm will view its demand as perfectly elastic BUT…the demand curve is not perfectly elastic for the industry WHY the difference?? Individual Firm’s Demand Curve Industry’s Demand Curve

Definitions of Revenue Total Revenue (TR) = Price multiplied by quantity sold (TR = P x Q) Average Revenue (AR)= price per unit for each firm in pure competition Marginal Revenue (MR) = ∆ in TR for each additional quantity sold AND will equal the unit price in conditions of pure competition

Profit Maximization in the Short Run Assumptions of the Firm Fixed plant By adjusting output: Will maximize profits OR Will minimize losses Profits = TR-TC 3 Questions each firm must answer: Should the firm produce If so, how much? What will be the profit or loss?

Profit Maximization Total Cost vs. Total Revenue Firms should produce if the difference between TR and TC results in a profit (TR > TC) Firms should produce that output which maximizes its profit or minimizes its loss Profit (or loss) = TR – TC Firms should not produce (“shut down”) if TR – TC <Average fixed costs Loss = Average fixed costs

TR – (ATC x Q) Profit Maximization Marginal Revenue vs. Marginal Cost MR = MC means that the firm will maximize profits (or minimize losses) at the point where MR = MC If MR < AVC (average variable cost), the firm will shut down In pure competition, P = MR (and P = MC) The firm will stop producing at the point where MR < MC Profit maximization = TR – (ATC x Q)

Determining Equilibrium Price Equilibrium price is where total QS = total QD Sum of individual firms production = industry (or total) QS Individual firms must take equilibrium price (“price takers”) Supply plans of all competitive producers is a major determinant of product price

Profit Maximization in the Long Run Assumptions: Entry and exit of firms are the only long-run adjustments Firms in the industry have identical cost curves The industry is a constant-cost industry (i.e. entry and exit of firms doesn’t affect costs of individual firms)

Profit Maximization in the Long Run Product price = Each firm’s point of minimum average total cost (ATC) If short term losses occur, firms leave the industry Qs decreases, P increases, profits increase If short term economic profits occur, firms will enter the industry Qs increases, P decreases, profits decrease or losses occur/increase

Profit Maximization in the Long Run Long run Supply: Constant cost industry Perfectly elastic supply curve Level of output will not affect the price in the long run Expansion or contraction does not affect resource prices or production costs Entry/exit will affect quantity of output but price will always revert to equilibrium price

Profit Maximization in the Long Run Long run Supply: Increasing cost industry Average cost curves shift upward as industry expands and downwards when it contracts If D increases, ATC increase as firms enter the industry, and P increases to maintain normal profit If D decreases, ATC decreases as firms exit the industry, P decreases, firms cannot attain above-normal profit

Profit Maximization in the Long Run Long-run Supply Decreasing cost industry Supply will be downward sloping ATC falls as the industry expands Firms will enter until price is driven down to maintain normal profits

Pure Competition and Efficiency Regardless of cost model, long run equilibrium will have the same characteristics: Productive efficiency occurs when P = minimum ATC Allocative efficiency occurs when P = MC If P > MC, then society values more units of good X and resources are underallocated to the production of good X If P < MC, then society values other goods more highly than good X and resources are overallocated to good X

Pure Competition and Efficiency Allocative efficiency implies maximum consumer and supplier surplus Combined consumer and supplier surplus is maximized at the equilibrium price