Chapter 8 & 9 Pure Competition What are the four basic market models of competition? What are the characteristics of purely competitive markets? How do purely competitive firms maximize profits (or minimize losses?) When will a firm shut-down? What are the long run adjustments to short run outcomes? How does long run equilibrium lead to economic efficiency?

Four Market Models How does a firm compete? In which market structure does it compete? I. Pure Competition (also called “perfect competition”) Large number of firms/sellers/producers Standardized product (commodity) like wheat, apples, roofing nails Easy entry and exit, few barriers to entry or exit from industry No control over market price

II. Monopolistic Competition (also called “differentiated competition”) Relatively large number of sellers producing differentiated products like restaurants, clothing, shampoo Nonprice competition—attributes such as quality, location, design. Emphasis on advertising, brand names, trademarks Few barriers to entry Some control over price of their product

III. Oligopoly A few sellers usually producing differentiated products Each firm is affected by the decisions of its rivals and must take those decisions into account when determining pricing and output policies (mutual interdependence) Significant obstacles to entry and exit Some price control If you were JetBlue, from whom would you buy your fleet of airplanes?

IV. Pure Monopoly One producer, one firm in the industry Unique product—no need to differentiate Control over price High barriers to entry Pure monopoly, monopolistic competition, and oligopoly are often referred to as imperfect competition (and most of the real economy is imperfect!)

Pure Competition: Demand Perfectly elastic for the firm! The firm can’t get a higher price by restricting output The influence of one firm on total market supply and market price is negligible. Average, Total and Marginal Revenue AR (per unit revenue) = P TR = P X Q or AR X Q MR = change in TR that results from selling one more unit of output.

Marginal Revenue Because P is constant in a purely competitive industry, MR is constant. Therefore, for the firm, MR = D = AR = P Graph:

Marginal Revenue—Marginal Cost Approach As long as MR exceeds MC, the firm should continue producing. Key micro output determining rule: MR = MC (Know this or else!!) In the short run, as long as the firm chooses to produce, it will maximize profit or minimize loss by producing that output where MR = MC Graph:

Short Run Profit Max The purely competitive firm can maximize economic profit only by adjusting output. (It has no control over price.) In the S/R, changing the amounts of variable resources (labor, materials) alters Q. Economic Profit = TR – TC (remember: normal profit is in TC)

Marginal Cost and S/R Supply The short run supply curve for a firm is the portion of the MC curve above its average variable cost curve. Upward sloping due to law of DMR; firm will produce more when price rises. Changes in prices of variable inputs or technology will change MC and cause a shift in the MC (supply) curve.

Profit Max in the Long Run Simplifying assumptions: all firms have identical costs and constant cost industry (resource prices unaffected by entry and exit of firms.) Key understanding: after long run adjustments are complete, market price will be exactly equal to, and production will occur at, each firm’s minimum ATC.

Graphically… Long Run Equilibrium Entry of firms eliminates economic profits (shifts market supply curve to right) Exit of firms eliminates loss (shifts market supply curve to left) In the real world, inferior entrepreneurs incur higher costs, are more inefficient and will be the first to exit.

Total Revenue – Total Cost Approach In a purely competitive industry with a given market price, the firm faces 3 questions: 1. Should we produce? 2. If yes, what amount should we produce? 3. What profit or loss will be realized? Break-even point: TR = TC The firm makes only a normal profit. Graph:

Shutdown Point If price is less than AVC at all levels of output, the firm should not produce. MR = MC Rule (revised): A competitive firm will maximize profit or minimize loss in the short run by producing that output at which MR = MC, provided that market price exceeds minimum AVC.

Loss Minimization The firm will produce at a loss as long as the firm’s total loss is less than total fixed costs. If at MR = MC, and MR exceeds AVC, then the firm can cover all of its variable costs and part of its fixed costs. When MR=AVC, the firm’s total loss is equal to its TFC. Graphically:

Long Run Supply Constant Cost Industry (special case) Contraction or expansion does not affect resource prices, therefore does not shift ATC curve of the firm Constant cost occurs in industries where the industry’s demand for resources is small in relation to the total demand for those resources

Long Run Supply Increasing Cost Industry (usual case) Most industries are increasing cost— entry of new firms bids up resource prices (and shift ATC higher. ) Exit of firms lower costs. Upsloping supply curve for resources

Pure Competition and Efficiency A competitive market economy uses society’s scarce resources in a way which maximizes consumer satisfaction. (Also maximizes the total consumer and producer surplus.) There are 2 types of efficiency…

Productive Efficiency P = min. ATC : goods produced in the least costly way. In the long run, pure competition forces firms to produce at and charge a price equal to min. ATC. Min. ATC forces firms to use the most efficient production techniques available to survive. Consumers benefit by paying the lowest product price possible.

Allocative Efficiency P = MC : mix of goods most wanted by society—resources allocated efficiently. Price reflects marginal benefit of the good Marginal cost reflects an opportunity cost (because other goods could be produced) When P > MC, there is an underallocation of resources to that good When P < MC, there is an overallocation Ideally, P = MC to reflect what consumers really want, i.e. efficient resource allocation.