Pure Competition in the Short Run 08 Pure Competition in the Short Run Explanations and characteristics of the four models are outlined at the beginning of this chapter, then the characteristics of a purely competitive industry are detailed. There is an introduction to the concept of the perfectly elastic demand curve facing an individual firm in a purely competitive industry. Next, the total, average, and marginal revenue schedules are presented in numeric and graphic form. Using the cost schedules from the previous chapter, the idea of profit maximization is explored. The total-revenue—total-cost approach is analyzed first because of its simplicity. More space is devoted to explaining the MR = MC rule, and to demonstrating how this rule applies in all market structures, not just in pure competition. Next, the firm’s short‑run supply schedule is shown to be the same as its marginal-cost curve at all points above the average-variable-cost curve. Finally, the short‑run competitive equilibrium is discussed at the firm and industry levels. Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Market Structure Continuum Four Market Models Pure competition Pure monopoly Monopolistic competition Oligopoly We will be discussing all four of these market models, but first we will start with pure competition. From the continuum, you can see that we are starting at one extreme of the possible market models. The other market models will be discussed in future chapters. Oligopoly Pure Competition Monopolistic Competition Pure Monopoly Market Structure Continuum 8-2 LO1

Monopolistic Competition Four Market Models Characteristics of the Four Basic Market Models Characteristic Pure Competition Monopolistic Competition Oligopoly Monopoly Number of firms A very large number Many Few One Type of product Standardized Differentiated Standardized or differentiated Unique; no close subs. Control over price None Some, but within rather narrow limits Limited by mutual inter-dependence; considerable with collusion Considerable Conditions of entry Very easy, no obstacles Relatively easy Significant obstacles Blocked Nonprice Competition Considerable emphasis on advertising, brand names, trademarks Typically a great deal, particularly with product differentiation Mostly public relation advertising Examples Agriculture Retail trade, dresses, shoes Steel, auto, farm implements Local utilities Pure competition is rare in the real world, but the model is important. The model helps analyze industries with characteristics similar to pure competition. The model provides a context in which to apply revenue and cost concepts developed in previous chapters. Pure competition provides a norm or standard against which to compare and evaluate the efficiency of the real world. 8-3 LO1

Pure Competition: Characteristics Very large numbers of sellers Standardized product “Price takers” Easy entry and exit Perfectly elastic demand Firm produces as much or little as they want at the price Demand graphs as horizontal line Very large numbers of independent sellers each acting alone cannot influence the market price by increasing or decreasing their output because each has such a miniscule part of the entire market. A standardized product is a product for which all other products in the market are identical and thus are perfect substitutes. The consequence of this is that buyers are indifferent as to whom they buy from. Price takers have no pricing power; in other words, no ability to price their product. Easy entry and exit means that there are no obstacles to entry or to exit the industry. Perfectly elastic demand means that firm has no power to influence price so the firm merely chooses to produce a certain level of output at the price that is given. The demand curve is not perfectly elastic for the industry; it only appears that way to the individual firm, since they must take the market price no matter what quantity they produce. The firm faces a perfectly elastic demand because each individual firm makes up such a small part of the total market and the goods are perfect substitutes. Note that this perfectly elastic demand curve is a horizontal line at the price. 8-4 LO2

Average, Total, and Marginal Revenue Average Revenue Revenue per unit AR = TR/Q = P Total Revenue TR = P X Q Marginal Revenue Extra revenue from 1 more unit MR = ΔTR/ΔQ When a firm charges the same price for each unit of output, the average revenue is just the price of the good. Total revenue refers to the total amount of money that the firm collects for the sale of all of the units of their good. Marginal revenue reflects the additional revenue that the firm will receive by producing one more unit of output. When the firm is deciding how much to produce, the firm considers the marginal revenue in their decision. 8-5 LO3

Average, Total, and Marginal Revenue Firm’s Demand Schedule (Average Revenue) Revenue Data TR P QD TR MR 1 2 3 4 5 6 7 8 9 10 $131 131 $0 131 262 393 524 655 786 917 1048 1179 1310 ] $131 131 This graph shows a purely competitive firm’s demand and revenue curves. The demand curve (D) of a purely competitive firm is a horizontal line (perfectly elastic) because the firm can sell as much output as it wants at the market price (here, $131). Because each additional unit sold increases total revenue by the amount of the price, the firm’s total-revenue (TR) curve is a straight upsloping line and its marginal-revenue (MR) curve coincides with the firm’s demand curve. The average-revenue (AR) curve also coincides with the demand curve. D = MR = AR 8-6 LO3

Profit Maximization: TR-TC Approach Three questions: Should the firm produce? If so, what amount? What economic profit (loss) will be realized? When looking at profit maximization there are essentially 3 questions that the firm must answer. The first question is whether or not the firm should produce at all in the short run. In the short run, the firm should shut-down under certain circumstances. If it has been determined that the firm should produce in the short run, then the firm must determine how much to produce. Lastly, based on the answers to the first two questions, it is necessary to calculate the profit or loss for the firm. Part of the profit-maximization rule is producing an output that minimizes losses in the short run when that is the best option. 8-7 LO3

Profit Maximization: TR-TC Approach The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price = $131) (1) Total Product (Output) (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Costs (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Profit (+) or Loss (-) $100 $0 $-100 1 100 90 190 131 -59 2 170 270 262 -8 3 240 340 393 +53 4 300 400 524 +124 5 370 470 655 +185 6 450 550 786 +236 7 540 640 917 +277 8 650 750 1048 +298 9 780 880 1179 +299 10 930 1030 1310 +280 In this table, total costs are given as well as total revenue. Here we can start identifying where the firm will choose to produce using the total revenue-total cost approach. Based on TR-TC, the firm will produce where the difference between total revenue and total cost is the greatest. Based on this approach, the profit maximizing output is 9 units when the price is $131. 8-8 LO3

Profit Maximization: TR–TC 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) Total Revenue, (TR) Maximum Economic Profit $299 Total Cost, (TC) P=$131 Break-Even Point (Normal Profit) The firm’s profit is maximized at an output of 9 units where total revenue, TR, exceeds total cost, TC, by the maximum amount. The vertical distance between TR and TC is plotted as a total economic profit curve. Total Economic Profit $299 8-9 LO3

Profit Maximization: MR-MC Approach The Profit-Maximizing Output for a Purely Competitive Firm: Marginal Revenue – Marginal Cost Approach (Price = $131) (1) Total Product (Output) (2) Average Fixed Cost (AFC) (3) Average Variable Costs (AVC) (4) Average Total Cost (ATC) (5) Marginal Cost (MC) Price = Marginal Revenue (MR) (6) Total Economic Profit (+) or Loss (-) $-100 1 $100.00 $90.00 $190 $90 $131 -59 2 50.00 85.00 135 80 131 -8 3 33.33 80.00 113.33 70 +53 4 25.00 75.00 100.00 60 +124 5 20.00 74.00 94.00 +185 6 16.67 91.67 +236 7 14.29 77.14 91.43 90 +277 8 12.50 81.25 93.75 110 +298 9 11.11 86.67 97.78 130 +299 10 10.00 93.00 103.00 150 +280 Compare MC and MR at each level of output. The firm should continue to expand output as long as MR is greater than MC. The firm will maximize profits by producing the last unit of output where MR still exceeds the MC, or where MR=MC. At the tenth unit MC exceeds MR. Therefore, the firm should produce only nine units to maximize profits. 8-10 LO3

Profit Maximization: MR-MC Approach $200 150 100 50 MR = MC MC P=$131 Economic Profit MR = P ATC Cost and Revenue AVC A=$97.78 Figure 8.3 shows the short-run profit maximization for a purely competitive firm. The MR=MC output enables the purely competitive firm to maximize profits or to minimize losses. In this case, MR (=P in pure competition) and MC are equal at an output, Q, of 9 units. At this output, P equals $131 and exceeds the average total cost, and A = $97.78, so the firm realizes an economic profit of P - A per unit. The total economic profit is represented by the green rectangle and is (Price - ATC) * 9. 1 2 3 4 5 6 7 8 9 10 Output 8-11 LO3

Still produce because P > minAVC Losses at a minimum where MR=MC Loss-Minimizing Case Loss minimization Still produce because P > minAVC Losses at a minimum where MR=MC In the short run the firm only has two choices: produce or shut-down. There is not enough time in the short run for the firm to get out of business. Given these options, sometimes the firm will produce, but still make a loss. In these situations, the loss from producing is smaller than the loss if the firm shut-down so this is the firm’s best choice. 8-12 LO3

Loss-Minimizing Case Loss Cost and Revenue Output MC ATC AVC MR = P $200 150 100 50 1 2 3 4 5 6 7 8 9 10 Output MC Loss A=$91.67 ATC AVC P=$81 MR = P Figure 8.4 shows the short-run loss minimization for a purely competitive firm. If price, P, exceeds the minimum AVC (here $74 at Q = 5) but is less than ATC at the MR = MC output (here 6 units) then the firm will earn losses, but it will produce. In this instance the loss is P - A per unit, where A is the average total cost at 6 units of output and price equals $81. The total loss is shown by the red area and is equal to (P–ATC)*6. V = $75 8-13 LO3

Short-Run Shut Down Point Shutdown Case Cost and Revenue $200 150 100 50 1 2 3 4 5 6 7 8 9 10 Output MC ATC V = $74 AVC MR = P P=$71 Short-Run Shut Down Point P < Minimum AVC $71 < $74 This graph shows the short-run shutdown case for a purely competitive firm. If price, P (here equal to $71), falls below the minimum AVC (here $74 at Q = 5), the competitive firm will minimize its losses in the short run by shutting down. There is no level of output at which the firm can produce and incur a loss smaller than its total fixed cost. In other words, the $100 fixed cost is the minimum possible loss. 8-14 LO3

Marginal Cost and Short-Run Supply The Supply Schedule of a Competitive Firm Confronted with the Cost Data in the table in Figure 8.3 Price Quantity Supplied Maximum Profit (+) Minimum Loss (-) $151 10 $+480 131 9 +299 111 8 +138 91 7 -3 81 6 -64 71 -100 61 There is a relationship between price and quantity supplied. Since P=MR for the competitive firm, the profit maximization rule MR=MC will yield the short run supply curve. The short run supply curve is the part of the MC that lies above the AVC curve. The schedule shows the quantity a firm will produce at a variety of prices 8-15 LO4

Marginal Cost and Short-Run Supply Cost and Revenues (Dollars) Quantity Supplied MC e P5 MR5 d ATC P4 MR4 c AVC P3 MR3 b P2 MR2 a P1 MR1 The schedule shows the quantity a firm will produce at a variety of prices. Firms continue to follow the profit-maximizing rule and produce where MR=MC. They will produce as long as the price is greater than the minAVC. Q2 Q3 Q4 Q5 8-16 LO4

Marginal Cost and Short-Run Supply Cost and Revenues (Dollars) Quantity Supplied S MC e P5 MR5 d ATC P4 MR4 c AVC P3 MR3 b P2 MR2 a P1 MR1 Here is a generalized depiction of how the marginal cost curve becomes the short run supply curve. Examine the MC for the competitive firm. If price is below AVC, then the firm should shut down and produce 0. If the price is equal to or above AVC, the firm should produce. The MC curve that is above the AVC curve becomes the short run supply curve. The break-even point is point d where the firm earns a normal profit because Price=ATC here. Shut-Down Point (If P is Below) Q2 Q3 Q4 Q5 8-17 LO4

3 Production Questions Output Determination in Pure Competition in the Short Run Question Answer Should this firm produce? Yes, if price is equal to, or greater than, minimum average variable cost. This means that the firm is profitable or that its losses are less than its fixed cost. What quantity should this firm produce? Produce where MR (=P) = MC; there, profit is maximized (TR exceeds TC by a maximum amount) or loss is minimized. Will production result in economic profit? Yes, if price exceeds average total cost (TR will exceed TC). No, if average total cost exceeds price (TC will exceed TR). We must work through these 3 questions sequentially every time we are confronted with a new market price. This is a great table that summarizes the steps that you need to go through to determine profit maximizing output. 8-18 LO3

Firm and Industry: Equilibrium Firm and Market Supply and the Market Demand (1) Quantity Supplied, Single Firm (2) Total 1000 Firms (3) Product Price (4) Demanded 10 10,000 $151 4,000 9 9,000 131 6,000 8 8,000 111 7 7,000 91 6 81 11,000 71 13,000 61 16,000 The market equilibrium condition is where quantity demanded equals quantity supplied. This will occur at a price of $111 and this price is the equilibrium, or market clearing price. We can see that the industry demand curve is a typical, downward sloping demand even though, for the firm, the demand curve is perfectly elastic and horizontal. 8-19 LO4

Firm and Industry: Equilibrium S = ∑ MC’s s = MC Economic Profit ATC d $111 $111 AVC D Short-run competitive equilibrium for (a) a firm and (b) the industry. The horizontal sum of the 1000 firms’ individual supply curves (s) determines the industry supply curve (S). Given industry demand (D), the short-run equilibrium price and output for the industry are $111 and 8000 units. Taking the equilibrium price as given, the individual firm establishes its profit-maximizing output at 8 units and, in this case, realizes the economic profit represented by the green area. Individual firms must take price as given, but the supply plans of all competitive producers as a group are a major determinant of product price. 8 8000 8-20 LO4

Fixed Costs: Digging Out of a Hole Shutting down in the short run does not mean shutting down forever Low prices can be temporary Some firms switch production on and off depending on the market price Examples: oil producers, resorts, and firms that shut down during a recession Firms have to determine whether or not producing in the short run will make their losses bigger or smaller. Firms hope that producing will help to reduce their losses, but if they are wrong their losses (their hole) might grow greater. If firms are forced to shut-down, the shut-down might be temporary. The firm may re-open when prices rise and therefore will be large enough for the firm to reap profits. 8-21