Chapter 5: Pure Competition Objectives of chapter 5: Pure competition characteristics Demand as seen by a purely competitive seller Profit maximization in the short-run Marginal cost and short-run supply Profit maximization in the long-run Pure competition and efficiency Chapter 5 by TITH Seyla

Introduction Market structures can vary in both the theoretical analysis and real world observation. If you want to go to buy Cell-card scratch card, you can go to thousands of sellers which are present almost everywhere. What happens in the market if one seller stop selling the scratch cards? What happens in the market if you stop buying Cell-card scratch cards? Chapter 5 by TITH Seyla

Pure competition characteristics Very large numbers of sellers and buyers Standardized product: identical products are produced by firms in the pure competition market. Buyers and sellers are price takers: no influence from any individual buyer and seller on the market. Free entry and exit in and out of the market. Chapter 5 by TITH Seyla

Demand as seen by a purely competitive seller Each purely competitive firm offers only a negligible fraction of total market supply. It must accept the price predetermined by the market. (sellers are price-takers) Perfectly elastic demand The demand curve of a competitive firm is perfectly elastic. Note that the market demand curve is different from the firm demand curve. The firm demand curve shows the relationship between the price and quantity demanded of the product the firm is producing. It is a straight horizontal line a price is fixed at any quantity demanded. Total revenue = Price x Quantity Average revenue = Total revenue / Quantity Marginal revenue = ∆ Total revenue / ∆ Quantity Chapter 5 by TITH Seyla

Demand as seen by a purely competitive seller Chapter 5 by TITH Seyla

Profit maximization in the short-run Because the purely competitive firm is a price take, it can maximize its economic profit only by adjusting its output. In the short-run, the firm has a fixed plant; therefore, the firm must adjust the variable resources (materials and labor) to adjust the level of output. There are two ways to determine the level of output at which a competitive firm will realize maximum profit or minimum loss (in case of loss). Total revenue and total cost comparison Marginal revenue and marginal cost comparison Chapter 5 by TITH Seyla

Total revenue and total cost comparison Economic profit = Total revenue – Total cost The firm will choose an output level (Q) that makes its economic profit maximum. Chapter 5 by TITH Seyla

Chapter 5 by TITH Seyla

Marginal revenue and marginal cost comparison The firm will make maximum economic profit when marginal revenue = marginal cost If the marginal revenue is greater than the marginal cost, this means that producing one more unit of the product will add economic profit to the firm (economic profit increases). If the marginal revenue is less than the marginal cost, this means that producing one more unit of the product will add negative economic profit (or economic loss) to the firm (economic profit decreases) Chapter 5 by TITH Seyla

Marginal revenue and marginal cost comparison Chapter 5 by TITH Seyla

Short-run equilibrium MR = P MR = MC P = MC Chapter 5 by TITH Seyla

Shutdown point This point is where AVC is at its minimum. Chapter 5 by TITH Seyla

Marginal cost and short-run supply The short-run market supply curve shows the quantity supplied by all firms in the market at each price when each firm’s plant and the number of firms remain the same. Chapter 5 by TITH Seyla

Chapter 5 by TITH Seyla

Market supply curve Chapter 5 by TITH Seyla

Market equilibrium Chapter 5 by TITH Seyla

Profit maximization in the long-run Entry and exit only: entry and exit of the firm are the only adjustments for profit maximization in the long-run. Identical cost: all the firms have the same cost. Constant-cost industry: the entry and exit of the firm do not affect the prices of the resources. Chapter 5 by TITH Seyla

Profit maximization in the long-run Entry eliminates economic profits. Chapter 5 by TITH Seyla

Profit maximization in the long-run Entry eliminates economic profits. Chapter 5 by TITH Seyla

Profit maximization in the long-run Exit eliminates economic losses. Chapter 5 by TITH Seyla

Profit maximization in the long-run Exit eliminates economic losses. Chapter 5 by TITH Seyla

A permanent change in demand A decrease in demand shifts the market demand curve leftward. The market price falls, and each firm decreases the quantity it produces. Chapter 5 by TITH Seyla

A permanent change in demand Economic losses induce some firms to exit in the long run, which decreases the market supply and the price starts to rise. Chapter 5 by TITH Seyla

A permanent change in demand A new long-run equilibrium occurs when the price has risen to equal minimum average total cost. Firms make zero economic profits, and firms no longer exit the market. Chapter 5 by TITH Seyla

A permanent change in demand A new long-run equilibrium occurs when the price has risen to equal minimum average total cost. Firms make zero economic profits, and firms no longer exit the market. Chapter 5 by TITH Seyla

External Economies and Diseconomies The change in the long-run equilibrium price following a permanent change in demand depends on external economies and external diseconomies. External economies are factors beyond the control of an individual firm that lower the firm’s costs as the industry output increases. External diseconomies are factors beyond the control of a firm that raise the firm’s costs as industry output increases. Chapter 5 by TITH Seyla

The long-run market supply curve Chapter 5 by TITH Seyla

The long-run market supply curve Chapter 5 by TITH Seyla

The long-run market supply curve Chapter 5 by TITH Seyla

Long-run equilibrium Chapter 5 by TITH Seyla

Long-run equilibrium P = MC = Minimum ATC Chapter 5 by TITH Seyla

Pure competition and efficiency Efficient Use of Resources Resources are used efficiently when no one can be made better off without making someone else worse off. Productive efficiency: P = Minimum ATC In the long-run, pure competition forces firms to produce at minimum average total cost of production. This means that the minimum amount of resources will be used to produce any particular output. Allocative efficiency: P = MC Underallocation: P > MC (the firm is not yet at the maximum profit point) Overallocation: P < MC (the firm is over the maximum profit point) Dynamic adjustment: ability to restore efficiency. Chapter 5 by TITH Seyla