21 Pure Competition

Chapter Objectives Names and Main Characteristics of the Four Basic Market Models Conditions for Perfect Competition How Do Purely Competitive Firms Maximize Profits or Minimize Losses Why the Marginal Cost and Supply Curves For Competitive Firms Are Identical How Industry Entry and Exit Create Economic Efficiency Differences Between Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries

Market Structure Continuum Four Market Models Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Imperfect Competition Pure Competition Monopolistic Competition Pure Monopoly Oligopoly Market Structure Continuum

Pure Competition Very Large Numbers Standardized Product “Price Takers” Free Entry and Exit Perfectly Elastic Demand Average Revenue Total Revenue Marginal Revenue Graphically…

Pure Competition P QD TR MR TR Price and Revenue ] D = MR = AR 2 4 6 8 10 12 131 262 393 524 655 786 917 1048 $1179 Quantity Demanded (Sold) Firm’s Demand Schedule (Average Revenue) Revenue Data TR P QD TR MR $131 131 1 2 3 4 5 6 7 8 9 10 $0 131 262 393 524 655 786 917 1048 1179 1310 ] $131 131 D = MR = AR

Profit Maximization in the Short Run Total Revenue-Total Cost Approach Consider: Should Product Be Produced? If So, In What Amount? What Economic Profit (Loss) Will Be Realized?

Profit Maximization in the Short Run Total Revenue-Total Cost Approach Price = $131 (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 (-) 1 2 3 4 5 6 7 8 9 10 $100 100 $0 90 170 240 300 370 450 540 650 780 930 $100 190 270 340 400 470 550 640 750 880 1030 $0 131 262 393 524 655 786 917 1048 1179 1310 $-100 -59 -8 +53 +124 +185 +236 +277 +298 +299 +280 Do You See Profit Maximization? Now Let’s Graph The Results…

Profit Maximization in the Short Run Total Revenue-Total Cost Approach 1 2 3 4 5 6 7 8 9 10 11 12 13 14 $1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 $500 Total Revenue and Total Cost Total Economic Profit Quantity Demanded (Sold) Break-Even Point (Normal Profit) W 21.1 Total Revenue, (TR) Maximum Economic Profit $299 G 21.1 Total Cost, (TC) P=$131 Break-Even Point (Normal Profit) Total Economic Profit $299

Profit Maximization in the Short Run Marginal Revenue-Marginal Cost Approach MR = MC Rule Important Features: Firm Will Shut Down Unless MR at Least Meets MC Profit Maximization in All Market Structures Can Be Restated P = MC

Profit Maximization in the Short Run Marginal Revenue-Marginal Cost Approach MR = MC Rule (2) Average Fixed Cost (AFC) (3) Average Variable Cost (AVC) (4) Average Total Cost (ATC) (1) Total Product (Output) (5) Marginal Cost (MC) (6) Marginal Revenue (MR) (7) Profit (+) or Loss (-) 1 2 3 4 5 6 7 8 9 10 $100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 $90.00 85.00 80.00 75.00 74.00 77.14 81.25 86.67 93.00 $190.00 135.00 113.33 100.00 94.00 91.67 91.43 93.75 97.78 103.00 $90 80 70 60 90 110 130 150 $131 131 $-100 -59 -8 +53 +124 +185 +236 +277 +298 +299 +280 Do You See Profit Maximization Now? No Surprise - Now Let’s Graph It…

Profit Maximization in the Short Run Marginal Revenue-Marginal Cost Approach MR = MC Rule W 21.2 Cost and Revenue $200 150 100 50 1 2 3 4 5 6 7 8 9 10 Output P=$131 MR = MC MC Economic Profit MR = P ATC AVC A=$97.78

Profit Maximization in the Short Run Marginal Revenue-Marginal Cost Approach MR = MC Rule Loss Minimizing Case Cost and Revenue $200 150 100 50 1 2 3 4 5 6 7 8 9 10 Output Lower the Price to $81 and Observe the Results! MC Loss A=$91.67 ATC AVC MR = P P=$81 V = $75

Profit Maximization in the Short Run Marginal Revenue-Marginal Cost Approach MR = MC Rule Short-Run Shut Down Case Cost and Revenue $200 150 100 50 1 2 3 4 5 6 7 8 9 10 Output Lower the Price Further to $71 and Observe the Results! MC ATC V = $74 AVC MR = P P=$71 Short-Run Shut Down Point P < Minimum AVC $71 < $74

Marginal Cost and Short-Run Supply Continuing the Same Numeric Example… Supply Schedule of a Competitive Firm Quantity Supplied Maximum Profit (+) or Minimum Loss (-) Price $151 131 111 91 81 71 61 10 9 8 7 6 $+480 +299 +138 -3 -64 -100 The Schedule Shows the Quantity a Firm Will Produce at a Variety of Prices and Results

Marginal Cost and Short-Run Supply Generalizing the MR=MC Relationship and its Use Cost and Revenues (Dollars) Quantity Supplied MC e P5 MR5 d ATC P4 MR4 c AVC P3 MR3 b P2 MR2 a P1 MR1 This Price is Below AVC And Will Not Be Produced Q2 Q3 Q4 Q5

Marginal Cost and Short-Run Supply Generalizing the MR=MC Relationship and its Use Cost and Revenues (Dollars) Quantity Supplied Examine the MC for the Competitive Firm MC Above AVC Becomes the Short-Run Supply Curve S Break-even (Normal Profit) Point MC e P5 MR5 d ATC P4 MR4 c AVC P3 MR3 b P2 MR2 a P1 MR1 Shut-Down Point (If P is Below) This Price is Below AVC And Will Not Be Produced Q2 Q3 Q4 Q5

Changes in Supply Firm and Industry Equilibrium Price Market Price and Profits Firm Versus Industry Graphically…

Changes in Supply Single Firm Industry W 21.3 Single Firm Industry p P S = ∑ MC’s s = MC Economic Profit ATC d $111 $111 AVC D 8 8000 Competitive Firm Must Take the Price that is Established By Industry Supply and Demand

Profit Maximization in the Long Run Assumptions Entry and Exit Only Identical Costs Constant-Cost Industry Goal of the Analysis Long-Run Equilibrium Entry Eliminates Profits Exit Eliminates Losses

Supply Readjustment Single Firm Industry 100 90,000 80,000 100,000 S1 MC $60 50 40 ATC $60 50 40 S2 MR D2 D1 An Increase in Demand Temporarily Raises Price Higher Prices Draw in New Competitors Increased Supply Returns Price to Equilibrium

Supply Readjustment Single Firm Industry 100 90,000 80,000 100,000 S3 MC $60 50 40 ATC $60 50 40 S1 MR D1 D3 A Decrease in Demand Temporarily Lowers Price Lower Prices Drive Away Some Competitors Decreased Supply Returns Price to Equilibrium

Long-Run Supply Curve Constant-Cost Industry S P P1 P2 P3 Q $50 Z3 Z1 Q P1 P2 P3 $50 S Z3 Z1 Z2 D3 D1 D2 Q3 Q1 Q2 90,000 100,000 110,000

Long-Run Supply Curve Increasing-Cost Industry Q S P2 $55 Y2 P1 $50 Y1 P3 $40 Y3 D2 D1 D3 Q3 Q1 Q2 90,000 100,000 110,000 How Would a Decreasing-Cost Industry Look?

Pure Competition and Efficiency Productive Efficiency P = Minimum ATC Allocative Efficiency P = MC Maximum Consumer and Producer Surplus Dynamic Adjustments “Invisible Hand” Revisited O 21.1

Long-Run Equilibrium Competitive Firm and Market Single Firm Market Price Quantity MC P=MC=Minimum ATC (Normal Profit) S ATC P MR P D Qf Qe Productive Efficiency: Price = Minimum ATC Allocative Efficiency: Price = MC Pure Competition Has Both in Its Long-Run Equilibrium

Efficiency Gains From Entry: Last Word The Case of Generic Drugs Competitive Model Predicts Lower Price and Greater Output With Increased Efficiency When New Producers Enter Market Example is Patented Drugs Patents Enable Greater Profits in Support of R&D and Accelerated Cost Recovery After Patent Period Generics Enter Market Profits Decrease and Quantities Increase Combined Consumer and Producer Surpluses Increase

Efficiency Gains From Entry: Last Word The Case of Generic Drugs New Producers Enter Market a Price Quantity As Price Decreases to f, Consumer Surplus abc Increases to adf Producer and Consumer Surplus is Maximized Together as Shown by the Gray Triangle S Initial Patent Price b c P1 d P2 f D Q1 Q2 Results: Greater Quantity at Lower Prices as Predicted by the Competitive Model

Key Terms pure competition pure monopoly monopolistic competition oligopoly imperfect competition price taker average revenue total revenue marginal revenue break-even point MR=MC short-run supply curve long-run supply curve constant-cost industry increasing-cost industry decreasing-cost industry productive efficiency allocative efficiency consumer surplus producer surplus

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